Question from reader regarding risk in option position
Aug 14, 2008
Reader: What are the risk/rewards for the following position: buy $5.70 May call - sell $8.00 May call - sell $5.00 May put, for a net cost of 20 cents?
Response: When you buy the $5.70 May call, you pay a premium and have all the upside potential of the position. When you sell the $8.00 call, you receive the premium. If you put the positions on at the same time, you pay the difference between the premium and you receive the difference between $5.70 and $8.
Let’s look at the numbers.
If the May $5.70 is at 61 cents and the May $8.00 is at 12 cents, you would pay a net premium of 48 cents plus commissions, clearing and related fees (let’s say 3 cents) for a total estimated cost of 51 cents or $2,550. At this point you are spending $2,550 of premium which is all “time value” for the right to make $11,500 if the market moves back to $8, resulting in a net gain of $8,950.
Up to this point you know exactly what your risk is because it is equal only to the premium paid. In this scenario, when you sell the $5.00 put you assume unlimited risk for a specified premium. In this case the May $5.00 put is going for 31 cents—commission and fees of 1.5 cents for a net of 29.5 cents. Remember, when you sell the put, you have “unlimited risk” so one would want to be selling puts close to the seasonal lows, which I believe we are currently entering.
When you implement the position, you must remember your initial cash flow will be $2,550 plus commission and fees for the long calls and you will be required to put up the margin requirement of the short puts that are based on the underlying futures contract. For planning purposes, I would suggest at least ½ of the underlying futures. So when you put the numbers together, you could be looking at an initial cost well in excess of $3,200 which is also well in excess of the margin requirement of futures.
So why not buy the futures contract? As anybody convinced that corn was going to $10 and bought futures would tell you, margin calls hurt and most of the time it forces you to do the wrong thing at exactly the right time. The biggest value of options is you know your risk; but you are paying for that right. The risk of the strategy you asked about is selling puts to long-term reduce the net cost by 29.5 cents. Since I believe we are in the final stages of this year’s bear market, I have no great difficulty recommending selling the puts.
The recommendations and opinions contained herein are based upon information from sources believed to be reliable. However, that information may be incomplete and unverified. There are numerous factors that can affect the markets, which cannot be fully accounted for in the preparation of these recommendations. Those following these recommendations do so at their own risk. The firm and/or customers of the firm may take a position that may not be consistent with the recommendations herein. Any recommendation does not constitute an offer to buy or sell or the solicitation of an offer to buy or sell any commodity interest. Commodity trading involves risks, and you should fully understand those risks before trading.