Saturday, September 1, 2012

a new trade on my favorite etf ...

iwm, the russell index etf, of course!
 
this week i put on a frank walsh style trade on iwm. frank is a frequent commentator/educator on the thinkorswim chats (what's frank thinking?). he has been advocating a trade that is combination of a covered-call and a naked put. if you understand the concept of put/call (call=stock+put) parity then you will immediately say, ah, but those are the same thing! true dat! if one plots the p&l graph for a covered call and a naked put at the same strike one gets the same hockey-stick graph with a fixed max profit on the upside and a long handle down to zero underlying price on the downside.
 
the same, but different! 
 
the difference is in how one thinks about and manages the trade. here's my full iwm position:
iwm full position
if i let this ride to expiration then there is a 65% chance of profit, which is very good. however, notice though that if i expire under the $81 strike then the call will go out worthless and leave me with a stock position (assuming i roll the put position.)
 
my goal is to set up a monthly trade like this. so i like to think differently about this position and another totally equivalent way to think about this trade is as a stock - straddle (long stock/short straddle) trade. if i buy back the options every month then the stock will persist in my account unless i am exercised early (not a terrible result actually.) so what i am left dealing with, month-to-month in the options, is a short straddle position (short a call and short the put.) the straddle has this p&l:
iwm straddle
here i have unchecked the stock position from the analysis and redrawn the break-even lines.  thus, there are three outcomes: <76, between 76 and 86, >86. here's my action plan for these three expiration-week outcomes:
 
  • <76. the call should be nearly worthless so i will roll the call to the same strike in the back month. if there is not sufficient value to call roll then i will consider a roll diagonally down but only to a 20 delta option. alternatively, i evaluate whether rolling further out in time is a better value. the put will be itm (in-the-money) and my action plan calls for rolling the put too. yea verily, this does write-down a loss but time is money, the roll, most often, generates a net credit. i will evaluate the roll value on the put when the time comes to see if maybe rolling deeper in time is a better value. with two-year leaps trading on iwm there is no shortage of deep-time options available.
  • between 76 and 86. in this range both options expire profitably and i simply roll them to the back month at the same strikes.
  • >86. same as <76 but reverse the logic for call and put.
in a nutshell that is it.
 
the tricky part is coming to grips with rolling the itm options. it's all in the way that one thinks about it. if you feel that buying back the itm option is a loss, and a loss is a loss, period, then maybe you need to follow a trade like this in a practice account first. there are always future months to roll to (otherwise we have bigger problems), thus, i have come to view the roll on the itm option as a loan. i am loaning the market some money and receiving what is usually very generous upfront interest payment on the loan in the form of the roll credit. i compare the roll credit to the size of the loss i am writing down, many times it is in excess of 30%. why would i eat the loss and throw away the opportunity!?
 
of particular note, in the case of an itm call, i am loaning out unrealized profits on the stock. the underlying might double or triple but i will always be able to roll that itm call because i have the stock. almost inevitiably the postion will retrace in some future month when stock holders get impatient or worried and i get to collect on my loan, keeping the "interest payments" of course. likewise for the itm put, but here i am loaning out cash from my account. that should be no problem though because otherwise my broker would not have let me sell the put in the first place and the most cash i would be loaning out is the strike price x 100, the cost of the shares.
 
all-in-all this trade strategy is heads i win, tails i win later.
 

dave says: true dat!


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