strike selection question

S

spreadn00b

I've been trading stocks for a number of years and options over the last couple of years (but always simply buying calls, or doing simple spreads). I am a very conservative trader and I'm always looking for a way to minimize risk (aren't we all?). I've been testing a theory and everything seems fine except for one thing.

I've used a trading system, tweaked here and there, over the years that goes long with a profit target and no stop loss (only a time based exit). I trade stocks with a low beta and haven't been bit, but having no stop loss always bothers me, even though I put less than 10% of the account on any given trade. Here's my question.

Let's say I were to substitute the underlying with a synthetic long instead. Now I want to put a collar around my synthetic to manage risk. Since I already have a hard profit target, and no stop loss, this collar will provide me with a way to have a stop loss (and profit target) but not get snuffed out of the trade. Let's take PEP for example, which closed today at 64.73. If I were to do a synthetic long with a collar, I have some choices.

Using theoretical for now, I could
B JAN07 67.50 Call @ 1.10
S JAN07 67.50 Put @ 2.60
S JAN07 70.00 Call @ 0.45
B JAN07 65.00 Put @ 1.30

for a credit of about 0.70 (rounding may make this more or less). According to my calculations, my maximum profit is 2.93 and my max loss is 1.80.

If I turn around and do this close to the money, I see this:
B JAN07 65.00 Call @ 2.20
S JAN07 65.00 Put @ 1.30
S JAN07 67.50 Call @ 1.05
B JAN07 62.50 Put @ 0.50

for a debit of around 0.35 and a max profit of 2.16 and a max loss of 2.84.

This seems a bit too good to be true. I surely don't get a higher R/R just because of the different strikes? What am I missing here?
 
Volatility...how will the change in IV affect your positions? or will they? Yar are alos closer to the money on the second one..gradtor risk reward?j This of course is predicated on getting the values you assume you will get.
 
It certainly has an effect, but not nearly as bad as I would think.

If I change the good spread from an IV of 11% to 22% turns out to be max P/L -2.04/2.70 from max P/L -1.80/2.93. The "bad" spread goes from max P/L -2.84/ 2.16 to -2.58/2.42. I typically hold for 15-25 days. Can vol double, sure. Is it likely, maybe I need some research on that.

Quote from RichardRimes:

Volatility...how will the change in IV affect your positions? or will they?
More...
 
Quote from spreadn00b:

[
Using theoretical for now, I could
B JAN07 67.50 Call @ 1.10
S JAN07 67.50 Put @ 2.60
S JAN07 70.00 Call @ 0.45
B JAN07 65.00 Put @ 1.30

for a credit of about 0.70 (rounding may make this more or less). According to my calculations, my maximum profit is 2.93 and my max loss is 1.80.


This seems a bit too good to be true. I surely don't get a higher R/R just because of the different strikes? What am I missing here? [/B]
More...
You've constructed a synthetic stock position which doesn't make sense. If your long call is 1.10 and your short put is 2.60 then you have a net credit of 1.50, giving you a synthetic stock price of 67.50-1.50=66. But your real stock is trading for 64.73. How come? If you can answer that then you have the answer to your dilemma.
Best
daddy's boy
 
Quote from spreadn00b:

I've been trading stocks for a number of years and options over the last couple of years (but always simply buying calls, or doing simple spreads). I am a very conservative trader and I'm always looking for a way to minimize risk (aren't we all?). I've been testing a theory and everything seems fine except for one thing.

I've used a trading system, tweaked here and there, over the years that goes long with a profit target and no stop loss (only a time based exit). I trade stocks with a low beta and haven't been bit, but having no stop loss always bothers me, even though I put less than 10% of the account on any given trade. Here's my question.

Let's say I were to substitute the underlying with a synthetic long instead. Now I want to put a collar around my synthetic to manage risk. Since I already have a hard profit target, and no stop loss, this collar will provide me with a way to have a stop loss (and profit target) but not get snuffed out of the trade. Let's take PEP for example, which closed today at 64.73. If I were to do a synthetic long with a collar, I have some choices.

Using theoretical for now, I could
B JAN07 67.50 Call @ 1.10
S JAN07 67.50 Put @ 2.60
S JAN07 70.00 Call @ 0.45
B JAN07 65.00 Put @ 1.30

for a credit of about 0.70 (rounding may make this more or less). According to my calculations, my maximum profit is 2.93 and my max loss is 1.80.

If I turn around and do this close to the money, I see this:
B JAN07 65.00 Call @ 2.20
S JAN07 65.00 Put @ 1.30
S JAN07 67.50 Call @ 1.05
B JAN07 62.50 Put @ 0.50

for a debit of around 0.35 and a max profit of 2.16 and a max loss of 2.84.

This seems a bit too good to be true. I surely don't get a higher R/R just because of the different strikes? What am I missing here?
More...

Of course, you get different risk/reward, cause you got different levels of protection. If the stock is at about 64.73 then in the first case your protection runs from ATM, in the second case your protection runs from 62.5, which is about 2.2 below current price.
Synthetic stock is synthetic stock, at any strike.

Btw, why don't you just buy the stock and collar it rather paying commissions and slippage on two options.
 
Quote from spreadn00b:

What am I missing here?
More...

Collars in various forms seem to come up on here quite a bit. The key is to be able to view a position in it's simplest form via some dissection.

In this instance, a collar is just a synthetic vertical

Trade the vertical and save yourself the commissions and slippage!


Using theoretical for now, I could
B JAN07 67.50 Call @ 1.10
S JAN07 67.50 Put @ 2.60
S JAN07 70.00 Call @ 0.45
B JAN07 65.00 Put @ 1.30
More...

This is a synthetic 65/70 bull vertical.


B JAN07 65.00 Call @ 2.20
S JAN07 65.00 Put @ 1.30
S JAN07 67.50 Call @ 1.05
B JAN07 62.50 Put @ 0.50
More...

This is a synthetic 62.50/67.50 bull vertical.

It should be obvious now why you get different risk/rewards. The two verticals are different.

In each case the max loss + max profit on the vertical = $5 which means your calculations on the first vertical are not correct.

Good luck.

MoMoney.
 
Thanks for the response and the suggestion. I do appreciate it.

Quote from MTE:

Of course, you get different risk/reward, cause you got different levels of protection. If the stock is at about 64.73 then in the first case your protection runs from ATM, in the second case your protection runs from 62.5, which is about 2.2 below current price.
Synthetic stock is synthetic stock, at any strike.

Btw, why don't you just buy the stock and collar it rather paying commissions and slippage on two options.
More...
 
Hrm ... so I can get the same result cheaper. Even better! Thank you very much. I have some testing to do.

Quote from momoneythansens:

Collars in various forms seem to come up on here quite a bit. The key is to be able to view a position in it's simplest form via some dissection.

In this instance, a collar is just synthetic vertical

Trade the vertical and save yourself the commissions and slippage!



This is a synthetic 65/70 bull vertical.



This is a synthetic 62.50/67.50 bull vertical.

It should be obvious now why you get different risk/rewards. The two verticals are different.

In each case the max loss + max profit on the vertical = $5

Good luck.

MoMoney.
More...
 
OK, so theoretically this isn't QUITE the same if I understand what you're saying. If you remember in my first post, the 65/70 collar had a P/L of 2.93/-1.80. The 65/70 bull vertical which I interpreted as buying a 65 call and selling a 70 call has a theroetical P/L of 1.07/-1.00. The 62.50/67.75 collar had a 2.16/-2.84, the bull vertical is 1.01/-1.11.

Please correct me if I'm wrong and thanks for adding some things to think about.


Quote from momoneythansens:

Collars in various forms seem to come up on here quite a bit. The key is to be able to view a position in it's simplest form via some dissection.

In this instance, a collar is just a synthetic vertical

Trade the vertical and save yourself the commissions and slippage!



This is a synthetic 65/70 bull vertical.



This is a synthetic 62.50/67.50 bull vertical.

It should be obvious now why you get different risk/rewards. The two verticals are different.

In each case the max loss + max profit on the vertical = $5 which means your calculations on the first vertical are not correct.

Good luck.

MoMoney.
More...
 
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