38 lines
3.0 KiB
Plaintext
38 lines
3.0 KiB
Plaintext
Chapter 24: Ratio Spreads Using Puts 365
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described for ratio call calendar spreads in Chapter 12. Suppose the stock in this
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example began to rally. There would be a point at which the strategist would have to
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pay 3 points of debit to close the call side of the combination. That would be his
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break-even point.
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Example: With XYZ at 65 at January expiration (5 points above the higher strike of
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the original combination), the near-term January 60 call would be worth 5 points and
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the longer-term April 60 call might be worth 7 points. If one closed the call side of
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the combination, he would have to pay 10 points to buy back two January 60 calls,
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and would receive 7 points from selling out his April 60. This closing transaction
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would be a 3-point debit. This represents a break-even situation up to this point in
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time, except for commissions, since a 3-point credit was initially taken in. The strate
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gist would continue to hold the April 50 put (the January 50 put would expire worth
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less) just in case the improbable occurs and the underlying stock plunges below 50
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before April expiration. A similar analysis could be performed for the put side of the
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spread in case of an early downside breakout by the underlying stock. It might be
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determined that the downside break-even point at January expiration is 46, for exam
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ple. Thus, the strategist has two parameters to work with in attempting to limit loss
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es in case the stock moves by a great deal before near-term expiration: 65 on the
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upside and 46 on the downside. In practice, if the stock should reach these levels
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before, rather than at, January expiration, the strategist would incur a small loss by
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closing the in-the-money side of the combination. This action should still be taken,
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however, as the objective of risk management of this strategy is to take small losses, if
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necessary. Eventually, large profits may be generated that could more than compen
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sate for any small losses that were incurred.
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The foregoing follow-up action was designed to handle a volatile move by the
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underlying stock prior to near-term expiration. Another, perhaps more common, time
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when follow-up action is necessary is when the underlying stock is relatively
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unchanged at near-term expiration. If XYZ in the example above were near 55 at
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January expiration, a relatively large profit would exist at that time: The near-term
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combination would expire worthless for a gain of 10 points on that sale, and the
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longer-term combination would probably still be worth about 5 points, so that the
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unrealized loss on the April combination would be only 2 points. This represents a
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total (realized and unrealized) gain of 8 points. In fact, as long as the near-term com
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bination can be bought back for less than the original 3-point credit of the position,
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the position will show a total unrealized gain at near-term expiration. Should the gain
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be taken, or should the longer-term combination be held in hopes of a volatile move
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by the underlying stock? Although the strategist will normally handle each position |