Tag Archives | LEAPS

Writing Calls Against LEAPS. Vega Risk

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Adjusting Iron Condors Part I



Hi Mark,

OK I did my homework on the following scenario and I am
confused.

My original idea was to buy
LEAPS VLO Jan 15 @ 4.35 and short Sept 18 Call at .40. You said:
"The volatility is more than a consideration. This trade is very vega
sensitive and I believe that if you make this play repeatedly, your
results will be based on IV."

I compared the HV [MDW: Historical volatility] and IV and they are relatively close at this point. [MDW:That tells you that IV may be at a reasonable level, but does not describe potential risk.]

I ran the numbers with IV decreasing and it does affect LEAPS pricing.  However, doesn't that imply the stock price is more
stable because IV typically decreases on rallies?  [MDW: Not always.  IV does rise and fall for reasons other than how the market has been recently trading.  And IV for a single stock can easily get separated from 'market IV']

I went to the CBOE site and ran the numbers, but my more important question is
this: I purchased the 15 strike LEAPS.  Let's
go worse case to the upside and assume company is a takeover target @30.00, with the deal closing before my short options (Sep 18C) expire.

This is how I am viewing the trade:
My long 15 call is worth 15+ any time value. [MDW: There will be zero time value if the takeover is for cash]
My short 18s  cost 12 and the loss is $11.60.
Although not profitable at this time [MDW: 'at this time'?  There is no other time.  You will shortly have cash and no investment], my net cost for the investment is 3.95 (4.35 – 0.40)…

My cost at
this point is 3.40 (15-11.60) exposing me to a .55c loss  [MDW: This is not an accurate calculation.  Your cost remains $3.95, per the previous paragraph,  The position is now worth $3.00. That's a 0.95 loss]

[MDW:Please let me know what part of the trade I am missing.

Don, You are missing the fact that a 95-cent loss on a $3.95 investment is a very bad result.  A 24% loss is significant.

You used a single, low-priced stock, trading with a 33 IV and want to discover generic rules that apply to all situations.  You see the dollars lost as a number, and not as a percentage of the investment.  That's not reasonable.  Try this with AAPL and consider the results.

As we know there
is no reward without risk but I see the two risks: 1.
Stock sinks;  2. Dramatic upside
move.
I am interested in hearing your thoughts. 

Yes, those are two of the risks.  Add another: an IV decline not related to a rally.

b) "Do you understand that by the time the stock hits 19, you are short
delta and continue to lose money on a continued rally?"

I don't get this
part and I am really trying to understand.  [The delta of your short option becomes higher than the delta of your long option.  Hence, you are net short delta and lose money on a price increase]


c) Look at the stock trading at 20. Drop IV by 25%. How does the trade
look now? How about 21 on the stock and IV down 50%?
I have not made any of these calculations. That's your assignment.  When
trading LEAPS, you want to know, not guess, what happens in a bunch of
'what if' scenarios.


OK, I did this hundreds of ways so that other readers and you can pick
apart my thinking:
I used 40% IV and then reduced it to 20% for VLO. 
I set up the trades as mentioned above.  [MDW: Don, The assignment was to help you decide if you really like this type of trade. My looking at the numbers does not help you develop a plan.

Is the risk/reward reasonable?  Can you make a wild stab at the potential reward?  What if IV declines and you must sell options @ 20 cents instead of 40 cents?]

[Don goes on to offer data, if you care to see the details, click here]


Thanks for reviewing this.  Hope I set it up in a way that makes sense.

Don

Yes, it makes sense.  But the data is for you to review

The bottom line remains.  When you own LEAPS, a plan such as yours is not unique.  Many try this plan, and everyone who adopts it owns the LEAPS for a long time.  The price of that option is very susceptible to changes in IV because these options are rich in vega. 

The other factor that followers of this strategy ignore, is the possibility that the monthly income stream can be cut in half or worse, when IV drops or the stock price declines.

This strategy can prosper.  But it has more risk than you see. 

760

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Book Review: Getting Started in Employee Stock Options

John Olagues and John Summa put together an interesting book.  It's an important read if you own, or know people who own, employee stock options (ESOs).

Getting Started in Employee Stock Options explains that most recipients of ESOs  exercise far earlier than the option expiration date – to lock in profits.  As option traders, all of you know that this is discarding many dollars worth of time value.


Olagues


The two Johns provide much guidance is hedging (reducing the risk of owning) ESOs.  If you can avoid exercising prematurely, there's a high probability that you will come out earning extra dollars by the time you do exercise the options.  If you have been exercising, or plan to exercise some of your ESOs in the foreseeable future, read this book. It's worth your time.

If you have friends or family members who earn ESOs and if they don't understand options very well (or at all), get this book as a gift.  They may not need your help, but if necessary, you can guide them through the basic option concepts. 

The book offers a detailed explanation of how people can hedge their options by using exchange-traded options in the same underlying stock.  Tactics include selling calls and/or buying puts, and the authors recommend trading LEAPS (longer-term options)

Why bother with hedging?  It's an intelligent way to maximize gains from those ESOs.  It makes no sense to throw away thousands of dollars in time premium when there are suitable alternatives.

Unfortunately, if your options were issued by a small company that does not have its options traded on an exchange, then simple direct hedging is not available.

Concerned about tax consequences of your hedging trades?  This book has the answers.

Want to know why companies love it when you exercise early?  There's a thorough discussion. HINT: Early exercise forfeits remaining time premium, and that's a gift to the company.

If there's something you want to know abut ESOs, this book has it.  The authors are not shy, offering their opinions on topics of significance.  The bottom line is that this book is not for everyone, but if you are among those who receive part of your compensation in the form of employee stock options, don't miss this book.  

725


Contest: Guess closing price for VXX on Jul 16, 2010

Best guess among non-subscribers: Win a one year subscription to Expiring Monthly

Best guess among subscribers: Win a 3-month package (Volatility Essentials) from ivolatility.com

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