40 lines
3.2 KiB
Plaintext
40 lines
3.2 KiB
Plaintext
394 Part Ill: Put Option Strategies
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Downside Protection. The actual downside break-even point might enter into
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one's thinking as well. A downside break-even point of 40.3 is available by using the
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LEAPS write, and that is a known quantity. No matter how far XYZ might fall, as long
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as it can recover to slightly over 40 by expiration two years from now, the investment
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will at least break even. A problem arises if XYZ falls to 40 quickly. If that happened,
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the LEAPS call would still have a significant amount of time value premium remain
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ing on it. Thus, if the investor attempted to sell his stock at that time and buy back
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his call, he would have a loss, not a break-even situation.
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The short-term write offers downside protection only to a stock price of 46.2.
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Of course, repeated writes of 6-month calls over the next 2 years would lower the
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break-even point below that level. The problem is that if XYZ declines and one is
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forced to keep selling 6-month calls every 6 months, he may be forced to use a lower
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striking price, thereby locking in a smaller profit ( or possibly even a loss) if premium
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levels shrink. The concepts of rolling down are described in detail in Chapter 2.
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A further word about rolling down may be in order here. Recall that rolling
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down means buying back the call that is currently written and selling another one
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with a lower striking price. Such action always reduces the profitability of the over
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all position, although it may be necessary to prevent further downside losses if the
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common stock keeps declining. Now that LEAPS are available, the short-term writer
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faced with rolling down may look to the LEAPS as a means of bringing in a healthy
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premium even though he is rolling down. It is true that a large premium could be
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brought into the account. But remember that by doing so, one is committing himself
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to sell the stock at a lower price than he had originally intended. This is why the
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rolling down reduces the original profit potential. If he rolls down into a LEAPS call,
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he is reducing his maximum profit potential for a longer period of time.
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Consequently, one should not always roll dm,vn into an option with a longer maturi
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ty. Instead, he should carefully analyze whether he wants to be committed for an
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even longer time to a position in which the underlying common stock is declining.
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To summarize, the large absolute premiums available in LEAPS calls may make
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a covered write of those calls seem unusually attractive. However, one should calcu
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late the returns available and decide whether a short-term write might not serve his
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purpose as well. Even though the large LEAPS premium might reduce the initial
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investment to a mere pittance, be aware that this creates a great amount of leverage,
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and leverage can be a dangerous thing.
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The large amount of downside protection offered by the LEAPS call is real, but
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if the stock falls quickly, there would definitely be a loss at the calculated downside
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break-even point. Finally, one cannot always roll down into a LEAPS call if trouble
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develops, because he will be committing himself for an even longer period of time to
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sell his stock at a lower price than he had originally intended. |