LEAPS

Started by Dexter, May 26, 2016, 09:57:42 PM

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Dexter

Has anyone successfully employed a LEAPS (Long-Term Equity Anticipation Securities) strategy?  If so, I'd be interested to hear what you did.  My results to date with LEAPS have been mixed.  But if LEAPS are used judiciously, they can be an excellent source of leverage -- just ask the guys at Cornwall Capital.

Dexter

#1
To add a little color to my comment about Cornwall Capital....

Cornwall Capital is a private investment company that made a fortune by shorting mortgage bonds during the 2007 credit crisis.  The individuals involved in this trade (Jamie Mai, Charley Ledley, and Ben Hockett) were profiled in the Michael Lewis book "The Big Short: Inside the Doomsday Machine."

In "The Big Short," Michael Lewis detailed not only Cornwall's short mortgage trade, but also some of their previous trades.  I found these previous trades just as interesting as their mortgage bond short.

In one of these trades, Cornwall used LEAPS to bet that Capital One Financial's (COF) stock would rebound. 

To provide some background...in July 2002, Capital One's stock fell 60% in two days.  This came on the heels of a management announcement that they were in a dispute about how much capital they needed to reserve against potential subprime losses with their two government regulators, the Office of Thrift Supervision and the Federal Reserve.  The market feared that Capital One was hiding losses and assumed that regulators had discovered fraud.

Cornwall had done a deep dive on Capital One and come to the conclusion that the company's dispute with its regulators was trivial and that the company was basically honest.

In the six months following the announcement of Capital One's dispute with its regulators, COF stock traded in a narrow band around $30 per share.  However, it was clear to Cornwall that $30 was not the right price.  The company was either a fraud, and worth nothing, or the company was honest and worth around $60 per share.

Cornwall decided to use LEAPS to put on a trade.  Cornwall bought LEAP options which gave them the right to buy Capital One's shares for $40 at any time in the next two and a half years at a cost of a bit more than $3.  Cornwall bought 8,000 LEAPS, which meant their potential losses were limited to the $26,000 their paid for the options.

The result, according to "The Big Short": "Soon after Cornwall Capital laid their chips on the table, Capital One was vindicated by its regulators, its stock price shot up, and Cornwall Capital's $26,000 option position was worth $526,000."

This is just one example of Cornwall Capital executing a successful trade using long-dated options.

Dexter

As a follow up to my previous post about Cornwall Capital's COF trade, I wanted to post some excepts from Jack D. Schwager's book "Hedge Fund Market Wizards: How Winning Traders Win."  In Chapter 7, Mr. Schwager interviewed Jamie Mai and they discussed the Capital One trade:

Schwager: What was the trade that you put on?
Mai: We thought buying the out-of-the-money calls provided the best way to express the trade because the potential bimodal outcome made a large price move much likelier than usual for the stock. Under these circumstances, the out-of-the-money calls were most mispriced and they had more embedded leverage. We were looking at buying the January 2005 $40 calls, which were trading near $5. Then there was some marginal bearish news, and the stock traded down to about $27. The calls we were looking to buy went down from $5 to $3.50. That was a big percentage move, which made the juice in the trade look that much greater, and we bought the calls.

Schwager: How long did you stay in the trade?
Mai: We held the options for over a year, during which time, Capital One stock fully recovered. We ended up making about six times our money on the calls.


As you can see, this interview fleshes out some of the details of Cornwall's Capital One trade.  The biggest discrepancy between this account and the one in "The Big Short" seems to be the amount of profit made.  In the Schwager interview, it sounds like Cornwall made around 6 times their money.  However, in "The Big Short," Lewis indicates they made around 19 times their money ($500,000 profit on an investment of $26,000).

I think the return mentioned in the Schwager interview is probably more accurate.  But either way, Cornwall made a ton of money on this trade using LEAPS.