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I am looking at this strategy of selling weekly calls against long LEAP put options

The strategy seems good to me. Quite an improvement over the regular collar strategy.

What I do not get is why does the author choose to buy an ITM put. If the goal was to not lose more than 5.6%, he could have chosen a out of money put where the strike is ~6% OTM.

Did he choose an ITM put because he does not want to pay any time premium? Does he not lose in wide bid-ask spreads what he gains by not paying time premium?

  • seems kinda messy him holding long shares at the same time and getting called out 30-40 times over the course of three years. Remember last week how I was saying something about rolling the weekly options early to close them out and gain an extra weekend of theta decay on the next weeks. – Knuckle-Dragger Apr 6 '15 at 20:16
  • @Knuckle-Dragger that whole article was messy – CQM Apr 6 '15 at 20:18
  • It's a terrible article whole premise is based on making you think that he has something really clever when all he is doing is using the more complex synthetic position to duplicate the simple one. IOW, buying shares and buying a deep ITM put is equivalent to buying the OTM call of the same series. Then he sells weekly calls against the position. Net-net, it's merely a diagonal spread. His way is capital intensive and incurs more B/A slippage and commissions. It's like asking what time it is and being to build a watch :->) – Bob Baerker Sep 13 '18 at 19:30
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What I do not get is why does the author choose to buy an ITM put. If the goal was to not lose more than 5.6%, he could have chosen a out of money put where the strike is ~6% OTM.

The reason why he is buying a ITM put instead of a put 5-6% below the ATM price, is because he wants to only lose 5-6% after all fee's. A put at 5-6% below ATM is not free, so it will not actually provide a 6% cushion, more likely 10%-15% maximum loss after it's cost is accounted for.

You cannot rely on the strike alone to determine the level of protection you are buying.

Real world example. SPY DEC 2017 195 strike put, costs $2150, it's about 6% OTM, but it costs roughly 10% of SPY $207, at best it would protect 85% of your net worth.

Strike - Costs = Protection

Did he choose an ITM put because he does not want to pay any time premium? Does he not lose in wide bid-ask spreads what he gains by not paying time premium?

Nope, you were just misunderstanding how he calculated his protection. He wanted to protect 5-6% after the cost of the hedge. He 'needed' to select an ITM put because time premiums are so high that an OTM put wouldn't suffice.

  • Thanks. Can I ask why you think the strategy was messy. How would you suggest to make it better – Victor123 Apr 7 '15 at 0:28
  • @Victor123 - because buying 100 shares long + buying a put = a synthetic long call. Much cheaper to just buy an OTM CALL at the same strike as the aforementioned ITM put. theoptionsguide.com/synthetic-long-call.aspx – Knuckle-Dragger Apr 7 '15 at 0:59
  • I don't understand. Put call parity holds for European options on non dividend stocks. More importantly, the synthetic relation holds if the strike of the call is equal to the strike of the put which needs to be equal to the underlying price. Am I missing something? – Victor123 Apr 7 '15 at 1:11
  • puts calls doesn't matter to me. or maybe what I mean is if you have $100,000 dollars to invest, don't do what that guy suggests and buy $100,000 in shares only to then spend another $6000 on a put so you can do a neat trick. Wasteful IMO. Instead spend only $6,000 on leap calls and keep $94,000 powder dry. You could buy 5 $230 strike DEC 2017 leap calls for the same $6000 and they won't expire for 32 months, 32*4 = 128 weekly covered calls. – Knuckle-Dragger Apr 7 '15 at 6:16
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So this is only a useful strategy if you already own the stock and want protection.

The ITM put has a delta closer to 1 than an OTM put. But all LEAPS have massive amounts of theta.

Since the delta is closer to 1 it will mimic the price movements of the underlying which has a delta of 1.

And then you can sell front month calls on that over time. Note, this strategy will tie up a large amount of capital.

  • Sorry,can you elaborate? If i already won stock and use the put just for protection, why would i want a deep ITM put? I would want an ATM put, correct? Also, 'massive' is a relative term, right? Just asking, please don't get offended. The theta of the 1 yr LEAP is certainly far less than 52 X the theta of a weekly. Does it still look massive? – Victor123 Apr 6 '15 at 21:12
  • @Victor123 massive in this case is just a reference to how it's proportion of the price of the option affects the delta. This is not about the daily decay the option experiences, this will be negligible. An ATM LEAP put does not offset the price of the underlying long position on a tick for tick basis as the delta will be far less than one. It will be closer to -.4 or -.3, so need a put with a delta closer to -1 to completely offset your long position of delta 1. Therefore you have to go deeper in the money. You need to understand delta and get your delta calculations to execute this strategy – CQM Apr 6 '15 at 21:16
  • Yes, I understand. But what if I am not concerned with day to day fluctuations (imagine a retirement account). I only care that at expiry, the max loss should not exceed 5% of my capital. So I can but a 5% OTM put, right? My question was: Is the trade off between the lower theta of ITM put and the wide bid ask spread of the ITM put? – Victor123 Apr 6 '15 at 21:26
  • @Victor123 I'll look into my risk models later on a few assets and see for myself about which LEAPS are practical. Regarding your main question, one thing to realize is that there is often times a lot of liquidity between the bid and the ask, depending on the asset. I've been willing to hit the far side of the spread and was filled nearer the midpoint by a previously invisible market participant (HFT). if that liquidity doesn't exist, then you have to calculate for urself, if you need to get out of a position then you have to accept the worst price. But you can place a limit order too and wait – CQM Apr 6 '15 at 21:32
  • How do you know it was HFT? And what do you mean by previously invisible? His order was not part of the order book? He just came in suddenly with a market order? – Victor123 Apr 7 '15 at 0:30

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