I have two strategies that I use. I'd like to run these by you for comment.
1. A biased stock market offers opportunities in ratioed collars. The stock market tends to drift or steadily move higher but can move lower with great speed. It tends to go up over time more than it goes down. How about long the index, short otm calls and long the more otm money puts maybe two to one the short calls so as to be premium neutral.
This idea is fine – to a point. Most collar traders prefer to take in some cash, but if that's not a concern, it's not a problem.
When you trade as suggested, the puts tend to become worthless as time passes – and offer protection only against a real disaster. With the 'normal' collar, the put offers better protection (higher strike price). The rationale for adopting your strategy is the opportuity to own extra puts, thereby giving you the chance to earn a big profit on a severe decline.
From my perspetive, your idea is neither 'better' nor 'worse.' It's making a choice:
Do you prefer to own one put that is closer to the money – or two puts, farther OTM – at the same cost? The former gives better protection most of the time. The latter sacrifices that 'better protection' for an occasional jackpot.
I find that traders often don't take the time to look at their positions as equivalent to other positiions that are easier to understand. You want to buy a collar. But you also want to embed a 2:1 put backspread.
You trade an index priced at 700 and decide to buy the 680P as part of a collar. With an IV of 30 and 60 days to expiration, the 680 put costs ~$24. To find a put priced at ~12, you would have to choose the 645P. And I'm giving you the benefit of the doubt by assuming that there is no volatility skew and that you can pay the same IV for the 645P as for the 680P. In reality, you would probably have to buy the 640 put to find one that costs only $12.
How do you feel about owning this position at even money? I ask because you do own this position when you construct your collar wih two puts per call.
Long 2 Apr 645P
Short 1 Apr 680P
Underlying index is 700; Expiration is in 60 days
The true problem with this strategy is that traders tend to hold positions until the options expire. With your plan, time is a real enemy and holding to the end is not a good idea. Here's why:
If the market really tanks or when IV surges, this spread is a winner – assuming it happens before too much time passes. If the market moves steadily lower, your 680 put threatens to become a costly short while the 645s fade slowly into oblivion.
That's true of any back spread. The point I am making is that unless you want to own black swan protection, these back spreads are tricky to manage. And that is especially true when you are an individual investor paying retail commissions.
I don't like the back spread for practical considerations, although the risk graph is definitely pretty. You may love it. That's ok. Please recognize that your suggested trade is merely tacking this backspread onto your standard collar. I think you'd be better served if you looked at the total package that way, rather than as 'something special' that you devised.
The back spread looks great on any risk graph – when the position is new and there's lots of time before the options expire. However, as time passes, it begins to look significantly worse.
My bottom line: This idea is sound if you recognize that you own the backspread plus the collar and that this combination is the position you want to own.
2. How about collecting premium (call credit spreads) to finance a long put position?
Owning futures (or stocks) can produce an account wipe-out on a big move lower.
Straight long options can kill with time decay.
But short an atm call spread and long an otm put solves both problems as long as commissions and the bid-ask in the options are not too bad.
This is simply one way to take a short position. Being short the call spread instead of selling anything naked is an excellent way to limit risk. That's important here because you own the put – a bearish position and are doubling up by selling the call spread. There is something in your style that likes owning extra options and finding a way to pay for them by taking in cash from a secondary trade.
There is nothing wrong with this idea. In fact, it's very similar to the 'risk reversal' strategy, in which the trader sells the call (not the spread) and buys the put. The call sale finances the cost of the put. I like your idea better becasue it involves buying an OTM put to protect the entire trade from resulting in a gigantic loss.
I find his to be a very reasonable bearish play (obviously this idea can be used for the corresponding bullish play).
No matter which underlying you trade, those wide bid/ask spreads that you mention can be a problem. One hint: You never know the true market until entering an order. I always try to trade near the mid-point of those wide markets – recognizing that I must take the short end of the stick. That means, paying a bit above the mid when buying and offering below the mid-point when selling. If I cannot get a 'decent' fill, I find something else to trade. Index options are actively traded and despite those horrible bid/ask spreads we see on our quote screeds, you should be able to get 'decent' fills when you enter spread orders.
Bottom line: These are reasonable ideas. You gain something in exchange for something else. That's always the difficult part about trading. We want the best of all worlds with our strategy, but it's always a trade-off. However, here is one compromise: Do a 'regular' collar, collecting a cash credit. Use that cash to buy some OTM puts. You own far fewer puts, but you have better protection. Just a thought.
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