Leap put protection for covered call

A

ausgate

I have been trading options on ASX for a few years, now looking a US trade that is not possible in OZ. Looking for any downsides.
Purchase CFC @ 4.80, buy jan10 put @ 2.05, sell jun5 call @.42.
The put should be payed for in 4-5 months leaving 13 months of call selling with no risk to original capital. Appreciate any comments.
 
1) The biggest risk is that the stock immediately goes to zero. You'll earn some money on the long-put and the short-call only once. At that point, there won't be any call-option strike prices that have any premium remaining in them.
2) You're better off not having the put-option. It eats up too many call-option premiums.
3) Consider doing covered-writes with stocks that do not have the potential for bankruptcy hanging over them.
4) Give more thought to identifying trending stocks instead of flat-liner stocks. You'll have better potential for bigger capital gains instead of collecting "small" call-option premiums.
 
What's the point of protecting a stock that is priced like an option (only 4.80). So if you want to bet on an up move just buy the stock and be ready to lose the whole 4.80 on it, period.

If you want fancy strategies then go with a "normal" priced stock.
 
You're taking on so much risk anyway, you might as well just write naked puts.

I mean, if you're going to pay $2 for a 5 strike put, then try to pick up the crumbs with covered calls every month, you're in for a rude awakening.

BAC is buying CFC in the next few months. If it falls through, CFC's going to zero, if it completes, it's going to turn into BAC stock (with the appropriate adjustments to options contracts). Either way you will lose money on your trade. If it goes to zero, there's not going to be any more covered calls you can write at any premium worthwhile. You will exercise your put to close out the position at a loss. If it spikes to the M&A value, your shares get called away, and you are left with a put worth very little.

If you really want to play CFC, you can try doing a merger & options volatility arbitrage.

My recommendation for that play would be:
- Short CFC Jan10 5 puts
- Long BAC Jan10 27.5 puts
Ratio of 11 CFC contracts <-> 2 BAC contracts
Net credit per 11 CFC/2 BAC contracts = $1510
I would add the following hedge to this trade:
SHORT 11 CFC Jan09 5 call. Net credit = $1408
LONG 2 BAC Jan09 37.5 call. Net debit = $540

Notional value of the trade:
$5500 Countrywide stock

Possible outcomes:
- BAC acquires CFC later this year, as anticipated, for $6.59 (current value) of BAC stock.
Your result: the 11 contracts of CFC Jan10 5 puts gets adjusted so it'll be approximately equal to the 2 BAC contracts you're short. (Profit: $1510) The ACTUAL adjustment will turn the deliverable of each CFC contract into 18 BAC shares and cash in lieu of .22 BAC shares
The Jan09 5/7.5 call spread gets adjusted to be approximately equivalent to a 27.44 / 37.5 BAC call spread. (Max loss: $1150 if BAC closes above 37.5 on expiration day. Assuming current prices, you'll probably lose $570 if you close it out right away)
Net profit: $940

- Deal falls through, CFC goes to zero
You're on the hook for the CFC 5 puts (Loss: $3990 - residual value of BAC 27.5 puts)
Your short 5 calls are worthless (Profit: $1408)
+ residual value of BAC 37.5 calls

Assuming residual values of the long options are half of what you paid for em, Net loss if CFC hits zero is $2022.

CFC has to be worth over $1.84 for you to not lose if the deal falls through.

- BAC revises so they pay $5 (.1388 BAC per CFC) per share
You'll be left with a net credit of $2378 from the trades, and the following positions after adjustments:
Long 36/37.5 Jan09 call spread (Max profit $300)
Short 27.5/36 Jan10 put spread (Max loss $2600)

If you close out all positions right away you'll probably walk away w/ $1000 profit in this scenario.

the CFC 5 vs BAC 27.5 spread is a basic options merger arbitrage trade.

the extra hedge offers some protection if the price for the deal is lowered (which may happen) or if the deal falls through.
 
Thanks for comments, CFC was a bad example of the trade it was first flat trend I brought up and did not look a any fundamentals. I was looking at placing these trades over several stocks. After margin about 100k to invest, the call premiums, after about 4-5 months are for income, the long 18 month put is to give 100% protection assuming I pick 5 Companys that are not going "belly up". I dont see how you could compare to selling 100k worth or naked puts?? Its not supposed to be a fancy trade it is a buy write with a focus on income rather than cg.
 
Aus -- long spot + long put = synthetic long call. When you add the short call you're trading a synthetic bull vertical spread. There is no advantage in trading the 3-way. The positions are equivalent.
 
Quote from ausgate:

I have been trading options on ASX for a few years, now looking a US trade that is not possible in OZ. Looking for any downsides.
Purchase CFC @ 4.80, buy jan10 put @ 2.05, sell jun5 call @.42.
The put should be payed for in 4-5 months leaving 13 months of call selling with no risk to original capital. Appreciate any comments.
More...
Think about this scenario. The stock rises significantly and the stock gets called away in June. Then you have to re-buy the $5 strike CC DITM with likely much less time value than the 42 cents you got for June. If the stock price stays higher repeated CC's with such low TV could mean you never pay for the protective put.

If you raise the CC strike price then your protective put doesn't cover all of the potential stock price drop.

A similar losing situation arises if the stock price goes significantly lower.

Don
 
Quote from ausgate:

I have been trading options on ASX for a few years, now looking a US trade that is not possible in OZ. Looking for any downsides.
Purchase CFC @ 4.80, buy jan10 put @ 2.05, sell jun5 call @.42.
The put should be payed for in 4-5 months leaving 13 months of call selling with no risk to original capital. Appreciate any comments.
More...

A. I did not understand where the strike of your put is (Is it 5?). I understand that the strike of your call is 5. Is it correct?

B. This is the same thing as long the put you bought, and short a put at the strike where you sell the call.

Therefore the same thing as buying a put leap, and selling shorter term puts. Doing it as a put-based spread will lead to a higher rate of return compared to what you are doing, as you will not be loaning funds to the market which is implicitely done when you buy stock and write call instead of selling the short term put. Dangers are price risk, but also volatility risk (if any) on the put leap. What is the vol for June, and the vol in the leap put?
 
try these senarios

$24k margined to $48k - buy 10000 stock @ 4.80
buy 100 of jan10 $5 puts @ $2.00 = $20k
sell 100 jun5 calls @ .42 = $4200

1.
price takes off, say $7 which equates to .2 cg = $2000 + $4200
2nd month
$47600 - buy 6800 stock @ 7.00
sell 68 jul7 @ .7 = $4760
3rd month price drops back, $6
$48000 - buy 8000 stock @ $6.00
sell 80 aug6 @ .48 = $3840

etc etc, after 4-5 months put payed for. 13 months selling calls

2.price drops, say $3.50 = no cg $4200 premium
2nd month
(17500 + 4200 x 2 = 43400) buy a further 2400 stock @ 3.50
sell 124 jul4 @ .25 = $3100
3rd month price up to $4.20, .5 cg + 3100 = $9300
keep 7k towards the sold put and buy 11400 @ 4.20
sell 114 aug4

etc etc. if the price falls re-invest the premiums until the 24k is replaced, never invest more than the 24k until the put is payed for. The put is to protect the 24k, pending any disaster surely the most you can lose is the put price less any premiums sold. The target is a year or more of sold calls.
 
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