This is the third 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) explained the combination of a long LEAPS call offset by very short-term short calls and puts. The second part (Part 2) explained the opening of a long LEAPS put, also offset by a series of short-term short options to offset the long premium cost. This 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.
The concept of “installment” timing of options refers to hedging one position against another, in terms of long versus short, as well as the use of different expiration cycles.
For example, trading offsetting calls in a diagonal with minimal spread between strikes creates a situation to exploit time decay while reducing market risk.
An example: Amazon.com was trading during the session of September 28 at $821.38 per share. At the same time, several calls could have been opened to set up a call-based hedge:
BUY Oct 14 820 calls, ask 14.25 plus trading cost = $1,434
SELL Oct 21 822.50 calls, bid 16.15, less trading costs = ($1,606)
SELL Oct 28 822.50 calls, bid 28.90, less trading cost = ($2,881)
NET credit = ($3,053)
This three-part hedging strategy includes a rationale for short-term bullish price behavior. The chart reveals why this is likely. Price has been moving strongly upward in a narrow channel with breadth of 40 points. Recently, price broke above this channel. However, this does not trigger an immediate bearish reversal since there are no reversal signals present.
In fact, trading has been above the 8-day EMA of the t-line for the most recent nine sessions. The t-line “rule” is that as long as price remains above, the trend remains bullish.
This means that at least for the next two weeks, expect to see continued bullish strength in AMZN. This, the October 14 calls, expiring in 16 days, are well situated at the moment. They also provide a 50% hedge against the October 21 and 28 short calls. In the event of early exercise of either of these, the October 14 covers at a 2.5-point advantage (820 strike versus 822.50 strike).
The net credit of $3,053 provides additional buffer. Because the channel has been interrupted, expectation is that during October, a retracement is likely to occur. The current price level is below the strikes, so as long as this persists, time decay works in favor of the positions. Once the short calls become profitable, they can be closed just as a result of time decay.
If the stock price rises above 822.50, moving both short calls in the money, several choices are available. With the cushion of $3,053, a new long call can be opened below this level to cover the ITM call. Second, either or both can be closed to take small losses (as long as the losses are below the cushion value of $3,053). Third, either or both short calls can be rolled forward to later expirations, setting up additional net credit. Again based on the cushion, it is even possible to roll forward to higher strikes, further reducing the exercise risk.
As a variety of the installment method, the use of calls in both long and short positions is maximized with this diagonal strike strategy. Not only does exercise result in a net profit, but focus on OTM strikes increases the opportunity for profits.
Any time a combination produces a cushion like this, the outcomes – even negative ones – can be more easily managed with secondary trades, taking small losses, or rolling to higher strikes.