need help in understand this option trade

N

NoEmotions

On Wednesday, 16 Jun 2010 in Fast Money , Mike Khouw of Cantor Fitzgerald told this option trade.

http://www.cnbc.com/id/37741224

***MIKE'S MS TRADE****
Sell the July 24 puts @ .60
Buy the July 26 calls pay .95
Sell the July 28 calls @ .25

How Mike's MS Trade Makes Money
Losses below 24
Get long at 24
Profits 26.10- 28

Question:

a) I am confused with "Get long at 24"

If I were to take this option trade and if MS touches or falls below 24 do I need to buy the stock with the buy order ? or automatically when July 24 put is exercise I will be long ?

b) how is the risk limited if the stocks breaks down below 24 ?

c) On TV ( also in the video in link )
with 1.7% upside he can make 9% upside and if the stock fell by 10% he only losses 3.5%
i don't understand that?

please someone explain
 
This is one of the flavors of what's known as a risk-reversal. This one consists of selling a put and buying a call spread.

1) Some people like to frame selling of puts by suggesting that it's equivalent to buying the underlying for the price determined by the strike of the put. Firstly, while this might be a reasonable way of thinking of the position at expiration, it might feel different, in terms of mark-to-market, during the lifetime of the trade. Secondly, he may be referring to "getting long" in the sense of delta. As to your specific question, if you're assigned on the 24 puts you're short (most likely when MS is below 24 at expiry), you'll have bought MS at 24.

2) To say that the risk of this position is limited is somewhat true, but rather disingenuous and wrong-headed. My guess is that they're implying that MS is likely to stay above 10 and is definitely not going to fall below 0.

3) I can't tell, off the top of my head, whether his calculation is correct, but it's easy enough to do with a simple options calculator.

EDIT: the payoff at expiry should look like the diagram in the scrshot attached (if I didn't mess things up). Hopefully, it helps.
 
You are effectively long at 24.10,should you be assigned on the short put and 26.1 on the upside with a max of 1.90 profit should MS be above 28.

In between 24 and 26 you lose .10


Quote from NoEmotions:

On Wednesday, 16 Jun 2010 in Fast Money , Mike Khouw of Cantor Fitzgerald told this option trade.

http://www.cnbc.com/id/37741224

***MIKE'S MS TRADE****
Sell the July 24 puts @ .60
Buy the July 26 calls pay .95
Sell the July 28 calls @ .25

How Mike's MS Trade Makes Money
Losses below 24
Get long at 24
Profits 26.10- 28

Question:

a) I am confused with "Get long at 24"

If I were to take this option trade and if MS touches or falls below 24 do I need to buy the stock with the buy order ? or automatically when July 24 put is exercise I will be long ?

b) how is the risk limited if the stocks breaks down below 24 ?

c) On TV ( also in the video in link )
with 1.7% upside he can make 9% upside and if the stock fell by 10% he only losses 3.5%
i don't understand that?

please someone explain
More...
 
Expanding on taowave's numbers...

He's buying a bullish July 26/28 call spread and funding most of it by selling the July 24 put. Net cost is 10 cts.

At exp, the bull spread has a maximum value of $2 above 28. With a 10 ct cost, the maxium profit is $1.90

B/t 24 and 26 the options worthless and you lose the dime.

Below 24 you'are assigned the stock (you buy it for $24). Since the options 10 cts, your net cost is $24.10


>> On TV ( also in the video in link ) with 1.7% upside he can make 9% upside and if the stock fell by 10% he only losses 3.5%
i don't understand that? <<

I have no clue how he comes up with his upside gain of 9% if the stock rises 1.7%. Ignoring slippage and commissions, a dime ITM (26.10) is a 100% gain. Even basing it on the stock's price doesn't compute.

His downside number is correct but what's really disingenuous is that the downside risk isn't limited to 3.5% (if the stock drops 10%). No stop loss order keeps it at 10% if there's a gap.

My two cents is that you should never sell a naked put unless you're a experienced/disciplined trader or you're willing to own the stock at the net cost. W/O that, selling it to fund an option purchase isn't a good idea.
 
I am with you..Early in my career,I would sell puts on companies selling at a significant discount based off of cash flow,thinking I would be thrilled to own the stock at those levels..

Rarely if ever was I thrilled when I was assigned....

Sell spreads to fund spreads..



Quote from spindr0:

Expanding on taowave's numbers...

He's buying a bullish July 26/28 call spread and funding most of it by selling the July 24 put. Net cost is 10 cts.

At exp, the bull spread has a maximum value of $2 above 28. With a 10 ct cost, the maxium profit is $1.90

B/t 24 and 26 the options worthless and you lose the dime.

Below 24 you'are assigned the stock (you buy it for $24). Since the options 10 cts, your net cost is $24.10


>> On TV ( also in the video in link ) with 1.7% upside he can make 9% upside and if the stock fell by 10% he only losses 3.5%
i don't understand that? <<

I have no clue how he comes up with his upside gain of 9% if the stock rises 1.7%. Ignoring slippage and commissions, a dime ITM (26.10) is a 100% gain. Even basing it on the stock's price doesn't compute.

His downside number is correct but what's really disingenuous is that the downside risk isn't limited to 3.5% (if the stock drops 10%). No stop loss order keeps it at 10% if there's a gap.

My two cents is that you should never sell a naked put unless you're a experienced/disciplined trader or you're willing to own the stock at the net cost. W/O that, selling it to fund an option purchase isn't a good idea.
More...
 
Quote from taowave:

I am with you..Early in my career,I would sell puts on companies selling at a significant discount based off of cash flow,thinking I would be thrilled to own the stock at those levels..

Rarely if ever was I thrilled when I was assigned....

Sell spreads to fund spreads..
More...
Heh! 30 years ago I was a covered call seller. Then I discovered equivalents and I became a naked put seller. Often, I'd roll the NP to the next month on expiration Friday.

Then we had a year where the DJIA dropped for a coupla months. My ability to adjust was reasonably good so I mitigated a chunk of the losses. But I still lost $$$. IV expanded and premiums looked fat. "KNOWING" (g) that a rebound was imminent, I stepped up the selling.

Did I mention that the day before the '87 crash was an expiration Friday??? All you can eat and then some!

Respect the naked option :)
 
spindr0 you said
>> "His downside number is correct but what's really disingenuous is that the downside risk isn't limited to 3.5% (if the stock drops 10%). No stop loss order keeps it at 10% if there's a gap."

Assume that the stock does not gap down huge how do I use stop orders with this trade to limit my risk ?

I assume the stop order needs to be put as soon as I enter the trade ( like GTC order type ) and before expiration is that correct ?

Thanks spindr0 and taowave for help.
 
Quote from NoEmotions:

Assume that the stock does not gap down huge how do I use stop orders with this trade to limit my risk ?

Determine your acceptable loss, subtract the cost of the position and place a buy to close order at that price on the short put.

I assume the stop order needs to be put as soon as I enter the trade ( like GTC order type ) and before expiration is that correct ?

Pardon the snark but what good would the stop loss order on the naked option do you after expiration? :) Or rephrased, what good would it do prior to your placing it?

So obviously, if you want whatever protection it affords, you have to place it as soon as you have a position that you want to protect.
More...
 
The position described by the OP would require that the trader have a bullish bias on the stock. That being the case, IMO it's a lot simpler and cleaner just to sell the put credit spread. I see no reason to make things more complex with the call spread legs.

You will know your risk up front, the lower strike acts as your stop-loss, and you pocket premium rather than a debit to enter the position.
 
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