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Writing Calls Against LEAPS. Vega Risk

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Hi Mark,

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

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
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.


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. 


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