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What is this AA? How to include options?
Old 10-13-2021, 10:40 AM   #1
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What is this AA? How to include options?

I recently bought some SPY Dec 2023 LEAPS as an equity substitute. In Dec 2023, I'll receive the then current value of SPY over the strike of 400, but I will not receive SPY's dividends between now and then. I'm debating with myself how to calculate my AA.

Hypothetical numbers. George owns 14 SPY LEAP contracts expiring in Dec 2023 with 400 strike... hypothetical cost was $100k... current value is $100k. Let's say SPY is currently trading at 435. Notional value is 14 contracts * 100 shares per contract *$450 price or $609k. In addition, George owns $900k of bonds. Total portfolio value is $1m.

View A: AA is 10/90... $100k LEAPs value/$1m total = 10% and $900k bonds/$1m total is 90%.

View B: since the options allow me to participate in changes in the value of SPY, I need to adjust my AA to reflect that. Substitute $609k notional value for $100k option value... so total is really $1,509k, with equity of $609k/$1,509k = 40% and fixed is $900k/$1,509k =60% so a 60/40 AA based on equity exposure and participation in rewards and risk. (though risk is limited to a loss of $100k the upside is theoretically unlimited).

ETA: View C: since the LEAPs is a stock substitute strategy, the $100k of LEAPS plus $509k of the $900k in bonds is similar to owning $609k of SPY directly... so George has $609k of equities and $391k of bonds for $1m total... or a 61/39 AA.

Other possibilities?

What do you think?
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Old 10-13-2021, 10:51 AM   #2
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Simple-minded engineer would value the LEAPS at today's price and include this number in my equity tranche. View A.

But is this question important or actionable? I would say no, hence would not lose sleep over it. God forbid that the FASB would show up and want to audit.
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Old 10-13-2021, 10:53 AM   #3
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Quote:
Originally Posted by pb4uski View Post
View B: since the options allow me to participate in changes in the value of SPY, I need to adjust my AA to reflect that. Substitute $609k notional value for $100k option value... so equity is $609k/$1,509k = 40% and fixed is $900k/$1,509k =60% so a 60/40 AA based on equity exposure and participation in rewards and risk. (though risk is limited to a loss of $100k the upside is theoretically unlimited).

Other possibilities?

What do you think?

I disagree with option B for a couple reasons. If you paid $100k, you can't immediately put $609k as the value - you miraculously just increased your portfolio value by $500k. I understand in this case, you're not really doing that but it's simply to get a reading on the effective amount of equity relative to the whole portfolio. But options are not equities. It doesn't even really represent the underlying stock, but the time value of the right to buy the stock at the strike price until expiration. So again, options are not equities, and I think that the only way that you might account for them if you're going to lump them in with your equity AA is somewhat in line with option A, where you've used the purchase cost. It's going to be the current option value day to day.
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Old 10-13-2021, 11:00 AM   #4
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Quote:
Originally Posted by OldShooter View Post
Simple-minded engineer would value the LEAPS at today's price and include this number in my equity tranche. View A.

But is this question important or actionable? I would say no, hence would not lose sleep over it. God forbid that the FASB would show up and want to audit.
No, the question is more academic curiosity... not planning on taking action and certainly won't be losing sleep over it.

It might have a practical impact if I was using FIRECalc or some other retirement calculator and it required my AA as an input.
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Old 10-13-2021, 11:41 AM   #5
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Not 100% sure of my convictions, but would choose choice A.
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Old 10-14-2021, 04:48 AM   #6
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Tough one. I agree that I would lean towards A. But since itís leveraged it will perform like a hyper equity in terms of ROI.

Is your view in buying these that you are bullish the market and is that why you like this method?

Whatís the delta of these calls? Iím guessing they still have some intrinsic value in them.
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Old 10-14-2021, 05:52 AM   #7
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The investment hypothesis is we are likely in bubble territory but I'm bullish in the long run... IOW, I think that SPY will increase between now and Dec 2023 but may take a big dive between now and then.

What I've been buying have ~$35 of intrinsic value and delta 0.64. (That's today, it was a little different when I bought them). The fixed side that the LEAPs are combined with (in my mind) are mostly investment grade preferred stocks that pay ~5.25% in dividends.

I prefer this approach because the upside is similar to being long on SPY but the downside is much more limited.
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