Collars: LEAPS Puts and Front-Month Calls
What will and won't work in options trading.
I've just recently begun learning about options and would like to know what you think about buying shares, buying an at-the-money LEAPS put, and then selling front month at the money calls against the stock.
I've had no luck searching the Web regarding this strategy. Once again, I'm at the point where I don't even know what I don't know and would appreciate your feedback.
You're already way ahead of most beginners by understanding that you "don't know what you don't know." It appears to me that you have read about several different principles of using options and are trying to put together a strategy that encompasses several of them. The problem with options is that one plus one is often unequal to two.
You're trying to adopt the collar strategy, and I don't know whether you realize that. The collar is a good, conservative method for protecting your assets when investing.
One problem with the typical collar is that you own puts than expire at the same time as the calls. Thus, the position doesn't provide anything attractive in the way of time decay, or positive theta. By owning options that expire in the second or third month, the benefits of theta come into play. Collars with puts that expire in three and six months, rather than the front month, have been shown to outperform traditional collars -- at least under the conditions of the specific study.
Your idea is to go whole hog and buy LEAPS puts -- to have a very pretty time decay position. Alas, it's not that simple.
Dave, there is one very serious problem with this strategy, and to me it dwarfs the rest of the discussion. Your obvious intent with this trade is to pay very little in time decay for your long LEAPS puts and to collect the very rapid time decay by selling near-term calls.
You do get that nice positive theta. And if you're lucky, and the price of the underlying doesn't change by too much month after month, this plan works like a charm.
But, you're going to be short gamma, which measures the rate at which you get long or short as the market moves. That front-month call has much more gamma than the LEAPS put. Your proposed trade has negative gamma. That means you get shorter and shorter when the market rises. It also makes you longer and longer as the market falls.
If the market rises significantly:
The call moves into the money and quickly moves point for point with the stock. Thus, your long stock vs. short call makes no money when that happens
- Your long put continues to lose value
- The greater the price increase, the more your put declines in value
- To make it even worse, most rallies are accompanied by a decrease in implied volatility. If you're not yet familiar with implied volatility, then you're indeed wading in far too deeply for a rookie trader. Bottom line: as implied volatility decreases, the value of your put decreases even more than it would on the rally. It's a double whammy
- This trade can do very poorly in a rising market. And that's a shame because a (traditional) collar is slightly bullish and doesn't lose money when the market rises. It limits gains, but doesn't lose money.
If the market falls significantly:
The call was inexpensive to begin with, and it soon becomes near worthless. It affords no additional profits on a decline
- The position becomes essentially long LEAPS put and long stock. You can look at this two different ways. This combination is equivalent to a long LEAPS call (I know equivalent positions may be another topic you haven't tackled, but it's very important to do so), and the call decreases in value -- quickly -- as the market falls. The alternative is to recognize that the put has a delta far less than that of the stock and gains value more slowly than the stock loses value. In either case, this loses money on a big decline
- To offset this loss, implied volatility tends to rise and that kicks into the picture by giving the put a bit of extra valuation. But it won't be sufficient to prevent losing money
- This trade does poorly in a falling market
Bottom line: You're betting on a relatively constant stock price -- and there are better alternatives for doing that. I do not like your suggested strategy.
But I'm glad you asked and hope this reply has been helpful.
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