This is the second part in a five-part series on the topic of installment options strategies. This involves a combination of a long-term long options, 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) explained the combination of a long LEAPS call offset by very short-term short calls and puts. This second part (Part 2) explains 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 part, Part 5, examines an expansion of these ideas with the use of straddles, strangles and synthetics as offsets.
A desirable options outcome is a cost-free hedge. However, these are difficult to establish unless you employ a combination of long-term and short-term positions. In some cases, this is more effective than swing trading short-term positions.
One day to accomplish this is with the installment put. This combines a long LEAPS put, paid for by a series of short puts, expiring on average every 7 to 14 days. As long as the short put strikes are lower than the long put strike, having the short position put to you can be converted into a profitable outcome by exercising the long put at a higher strike.
However, the goal here is not to accept and pay for exercise, but to create a series of installment credits to pay for the long put. It sets up a hedge of that long put so that if and when the underlying price declines below the put’s strike, you can create profits, often substantial profits. The long put (paid for with a series of very short-term short puts) ends up with a zero basis; if the stock price falls lower, it can be sold at a profit.
Meanwhile, the short puts expire rapidly and can be easily managed. With accelerated time decay, they will expire worthless, or can be sold to take profits, or can be rolled forward to avoid exercise.
For example, as shown on the chart of Amazon.com (AMZN), this strategy works well based on the narrow channel in which the stock has been trading since the beginning of August. The breadth of this channel is only 20 points, and the chart reflects the condition as of the close of September 16, the third Friday and last trading day of the September options.
A typical installment put can be set up with the following trades:
BUY one June 16, 2017 780 put (expires in 270 days), ask 75.35 (add trading fees, total cost = $7,544).
SELL one September 30, 2016 777.50 put (expires in 11 days), bid 9.50 (less trading fees, net cost = $941)
By executing similar trades as this 8 times during the next 270 days, the long put will be entirely paid for. This demonstrates how easily the offset can be accomplished, converting the expensive long put into a zero-basis long position (or even a profitable one).
By the end of the term in 270 days, if the underlying price is higher than the 780 strike, no action is needed because the put would be out of the money. Alternatively, it can be sold well before than expiration. With a basis of zero, the sale yields profits from time value alone.
If the underlying price is below the 780 strike, intrinsic value will be equal to the number of points difference. For example, if AMZN were to retreat back to its early May, 2016 levels of $660 per share, the 780 put could be sold for a net profit of $12,000 (780 strike less 660).
The installment put sets up a method to exploit one- to two-week time value in an easily manageable series of short put trades, for the purpose of paying for the long put nine months away. This completely hedges the underlying price below the strike, setting up potentially large profits if the stock price retreats.