This is the first part in a five-part series on the topic of installment options strategies. This involves a combination of a long-term long position, offset by a series of short-term short positions. The goal is to generate income in order to pay for the long option and reduce its net basis down to zero. This sets up effective hedging outcomes while keeping risks under control.

This first part (Part 1) explains the combination of a long LEAPS call offset by very short-term short calls and puts. The second part (Part 2) will explain the opening of a long LEAPS put, also offset by a series of short-term short options to offset the long premium cost. Part 3 explores the shorter-term use of a long call as a speculative trade, offset by shorter-term short calls. Part 4 is similar to Part 3, but involving speculation in puts. And the last installment, Part 5, examines an expansion of these ideas with the use of straddles, strangles and synthetics as offsets.

We could all use a no-cost option strategy that freezes the stock price for the next nine months. This allows you to buy the stock at a fixed price even if the price goes much higher in coming months. In the alternative, this strategy sets up a safe and potentially profitable short position with programmed net profits in the event of exercise.

How is this possible?

The real challenge is combining low risk, no cost and frozen price per share, all for future purchase of shares as one outcome, or profitable options trading as another. This installment call strategy is elegant in how it sets up a great hedge.

There are two primary parts to this. First is the purchase of a LEAPS call. Second is a series of short puts or calls expiring in one week to 10 days, aimed at paying for the long call in a series of installments.

At the point near expiration of the long call, several choices are available. First, if the stock price has fallen below the strike, no action is needed. The cost of the long call has been paid for by the sale of a series of short options.

If the stock price has risen above the call’s strike, you can sell the call and take profits. The intrinsic value of the call is 100% profit because the initial cost of the call has been offset with the short puts previously sold.

The third alternative is to exercise the long call and buy shares at the fixed strike, which by this time would be well below current market value. This would be a worthwhile alternative if the eventual goal would be to use 100 shares to set up a series of covered call, covered straddles or short strangles, or synthetic short stock positions. In each of these, the short call would be covered by ownership of stock, and the short put has the same market risk as the covered call. Even if you are not oriented toward stock ownership, the safety of covered calls versus uncovered makes this long-term strategy a great cash cow with little risk (especially compared to uncovered call writing).

The long-term LEAPS call is offset by very short-term short positions. Focusing on 7-10 day expirations, time value decays rapidly so it is easy to close at a profit or to allow the option to expire worthless. By monitoring the status of the short option for the very limited time exposure, you can consistently generate profits over time.

Here’s an example of the strategy, based on Chipotle (CMG) as of the close of September 16, 2016.

artile-9-24

The stock price was trading in a 50-point range over the most recent three months, with large movement between top and bottom in an average of two-week swings. That’s a lot of volatility and a great opportunity for options trading.

To set up this contingency installment strategy, the first step is to pick the LEAPS call. A focus on a call with strike below current price is a smart strategy because this can be used to satisfy assignment of a higher-strike short call, setting up a net profit. For example, look at the March 17, 2017 expirations, expiring in about 180 pays, half a year away. A 400 strike call closed on September 16 with an ask of 42.80. Adding trading fees, the estimate cost for this long call is $4,289.

To pay for this long call, write a series of short options between now and expiration. Also based on the September 16 close, the 410 call was at a bid of 5.00. After subtracting trading fees, this would net out at $491. It’s very close to the money, so over the six days until expiration, time decay will be rapid. It is reasonable to expect to buy to close at a profit or to wait out worthless expiration. The worst-case plan kicks in if the price rises above $410 per share. In that case, the short call can be closed or rolled forward. If assignment occurs, you are required to deliver 100 shares at $410, but you can close out your 400-strike long call and realize a profit of 10 points. This is the least desirable, however, because your basis in that long call is $4,289. So rolling or quickly closing is more rational. This short call at the money with only a few days until expiration offers a better than average chance for profitable outcome.

The alternative is to sell uncovered puts, which have the same market risk as covered calls. For example, the 6-day 405 put closed on September 16 at a bid of 2.55, so it would yield a net of $246. This is five points out of the money with less than one week until expiration, a very advantageous position.

A series of short calls based on the premium would have to be opened at least 9 times in the next 180 days to offset the cost of the long call. Or a series of short puts would have to be traded on average 18 times based on current premium levels.

Which is best to use? The chart answers that question. With the 50-point swings seen in recent months, the timing for the short position should be set based on proximity of price to resistance (perfect timing for the short call) or support (better timing for the short put).

This call-based installment strategy is low-risk and provides plenty of flexibility given the long time span. The fact that it freezes the cost of stock in the event you exercise the call next March, is a tremendous opportunity for anyone who would like to own CMG, but is not sure about whether or not the price will continue to rise. Even if this is aimed solely at exploiting short call positions in the future, this is one way to hedge risks.