38 lines
2.9 KiB
Plaintext
38 lines
2.9 KiB
Plaintext
Chapter 23: Spreads Combining Calls and Puts 355
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out-of-the-money combination. By adhering to this criterion, one gives himself area
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sonable chance of being able to buy the near-term straddle back for a price low
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enough to result in owning the longer-term options for free. In the example used to
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describe this strategy, the near-term straddle was sold for 7 while the out-of-the
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money, longer-term combination cost 4 points. This satisfies the criterion. Finally,
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one should limit his possible risk before near-term expiration. Recall that the risk is
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equal to the difference between any two contiguous striking prices, less the net cred
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it received. In the example, the risk would be 5 minus 3, or 2 points. The risk should
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always be less than the credit taken in. This precludes selling a near-term straddle at
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80 for 4 points and buying the put at 60 and the call at 100 for a combined cost of 1
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point. Although the credit is substantially more than one and one-half times the cost
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of the long combination, the risk would be ridiculously high. The risk, in fact, is 20
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points ( the difference between two contiguous striking prices) less the 3 points cred
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it, or 17 points - much too high.
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The criteria can be summarized as follows:
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1. Stock near middle striking price initially.
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2. Three to four months to near-term expiration.
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3. Price of written straddle at least one and one-half times that of the cost of the
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longer-term, out-of-the-money combination.
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4. Risk before near-term expiration less than the net credit received.
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One way in which the strategist may notice this type of position is when he sees a rel
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atively short-term straddle selling at what seems to be an outrageously high price.
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Professionals, who often have a good feel for a stock's short-term potential, will some
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times bid up straddles when the stock is about to make a volatile move. This will
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cause the near-term straddles to be very overpriced. When a straddle seller notices
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that a particular straddle looks too attractive as a sale, he should consider establish
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ing a diagonal butterfly spread instead. He still sells the overpriced straddle, but also
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buys a longer-term, out-of-the-money combination as a hedge against a large loss.
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Both factions can be right. Perhaps the stock will experience a very short-term
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volatile movement, proving that the professionals were correct. However, this will
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not worry the strategist holding a diagonal butterfly, for he has limited risk. Once the
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short-term move is over, the stock may drift back toward the original strike, allowing
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the near-term straddle to be bought back at a low price - the eventual objective of
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the strategist utilizing the diagonal butterfly spread.
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These are admittedly three quite complex strategies and thus are not to be
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attempted by a novice investor. If one wants to gain experience in how he would
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operate such a strategy, it would be far better to operate a "paper strategy" for a |