38 lines
2.9 KiB
Plaintext
38 lines
2.9 KiB
Plaintext
Chapter 25: LEAPS 401
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At this point, if XYZ rises in price by 1 point, the spread can be expected to lose 20
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cents, since the delta of the short option is 0.20 greater than the delta of the long
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option.
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This phenomenon has ramifications for the diagonal spreader of LEAPS. If the
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two strike prices of the spread are too close together, it may actually be possible to
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construct a bull spread that loses money on the upside. That would be very difficult
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for most traders to accept. In the above example, as depicted in Table 25-4, that's
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what happens. One way around this is to widen the strike prices out so that there is
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at least some profit potential, even if the stock rises dramatically. That may be diffi
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cult to do and still be able to sell the short-term option for any meaningful amount
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of premium.
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Note that a diagonal spread could even be considered as a substitute for a cov
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ered write in some special cases. It was shown that a LEAPS call can sometimes be
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used as a substitute for the common stock, with the investor placing the difference
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between the cost of the LEAPS call and the cost of the stock in the bank (or in T
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bills). Suppose that an investor is a covered writer, buying stock and selling relative
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ly short-term calls against it. If that investor were to make a LEAPS call substitution
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for his stock, he would then have a diagonal bull spread. Such a diagonal spread
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would probably have less risk than the one described above, since the investor pre
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sumably chose the LEAPS substitution because it was "cheap." Still, the potential
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pitfalls of the diagonal bull spread would apply to this situation as well. Thus, if one
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is a covered writer, this does not necessarily mean that he can substitute LEAPS calls
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for the long stock without taking care. The resulting position may not resemble a cov
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ered write as much as he thought it would.
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The "bottom line" is that if one pays a debit greater than the difference in the
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strike prices, he may eventually lose money if the stock rises far enough to virtually
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eliminate the time value premium of both options. This comes into play also if one
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rolls his options down if the underlying stock declines. Eventually, by doing so, he
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may invert the strikes - i.e., the striking price of the written option is lower than the
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striking price of the option that is owned. In that case, he will have locked in a loss if
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the overall credit he has received is less than the difference in the strikes - a quite
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likely event. So, for those who think this strategy is akin to a guaranteed profit, think
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again. It most certainly is not.
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Backspreads. LEAPS may be applied to other popular forms of diagonal spreads,
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such as the one in which in-the-money, near-term options are sold, and a greater quan
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tity of longer-term (LEAPS) at- or out-of-the money calls are bought. (This was
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referred to as a diagonal backspread in Chapter 14.) This is an excellent strategy, and |