42 lines
2.8 KiB
Plaintext
42 lines
2.8 KiB
Plaintext
406 Part Ill: Put Option Strategies
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nificant assumption that volatility and interest rates are unchanged). If XYZ trades
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higher than llO, the diagonal spread will lose some of its profit; in fact, if XYZ were
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to trade at a very high price, the diagonal spread would actually have a loss (see Table
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25-4). Whenever the purchased LEAPS call loses its time value premium, the diag
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onal spread will not perform as well.
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If the common stock drops in price, the diagonal spread has the greatest risk in
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dollar terms but not in percentage terms, because it has the largest initial debit. If
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XYZ falls to 80 in three months, the spread will lose about $1,100, just over half the
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initial $2,050 debit. Obviously, the short-term spread would have lost 100% of its ini
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tial debit, which is only $500, at that same point in time.
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The diagonal spread presents an opportunity to earn more money if the under
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lying common is near the strike of the written option when the written option expires.
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However, if the common moves a great deal in either direction, the diagonal spread
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is the worst of the three. This means that the diagonal spread strategy is a neutral
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strategy: One wants the underlying common to remain near the written strike until
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the near-term option expires. This is a true statement even if the diagonal spread is
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under the guise of a bullish spread, as in the previous example.
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Many traders are fond of buying LEAPS and selling an out-of-the-money near
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term call as a hedge. Be careful about doing this. If the underlying common rises too
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fast and/or interest rates fall and/or volatility decreases, this could be a poor strategy.
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There is really nothing quite as psychologically damaging as being right about the
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stock, but being in the wrong option strategy and therefore losing money. Consider
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the above examples. Ostensibly, the spreader was bullish on XYZ; that's why he chose
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bull spreads. If XYZ became a wildly bullish stock and rose from 100 to 180 in three
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months, the diagonal spreader would have lost money. He couldn't have been happy
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- no one would be. This is something to keep in mind when diagonalizing a LEAPS
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spread.
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The deltas of the options involved in the spread will give one a good clue as to
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how it is going to perform. Recall that a short-term, in-the-money option acquires a
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rather high delta, especially as expiration draws nigh. However, an in-the-money
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LEAPS call will not have an extremely high delta, because of the vast amount of time
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remaining. Thus, one is short an option with a high delta and long an option with a
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smaller delta. These deltas indicate that one is going to lose money if the underlying
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stock rises in price. Consider the following situation:
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XYZ Stock, 120:
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Call
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Long 1 January LEAPS 100 call:
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Short 1 April 110 call:
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Position Delta
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0.70
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-0.90 |