This is the fourth 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. The Part 3 explained 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 installment strategy may take many shapes and sizes, involves calls or puts, and be short-term or long-term. This article deals with the use of puts in a diagonal ratio, with the purpose of creating profits while hedging risk.
In a situation where short-term bearish sentiment is likely, this involves buying a short-term put and then selling longer-term, lower-strike puts. In this way, early exercise of the short puts can be met with the long put at a profit (due to differences in the strike). However, if the expected decline is short-term, then a swing back to the upside leads to worthless status for the short puts or for decline in price adequate to enter a buy to close at a net profit.
The key to this strategy is to set up a large enough net credit to add flexibility. In the event one of the shorts moves to the money and has to be closed at a loss, the net credit enables you to retain an overall net profit.
For example, the chart for Priceline (PCLM) exhibits a long-term gradual bull trend. As of the closing on September 28, the price of stock was $1,458.03 per share. However, the price pattern reveals a trading range of approximately 50 points, with current price near the top of that range. Expecting a short-term decline, the put-based installment strategy makes sense.
Based on the same date as the price chart, the following options could be opened with closing prices on September 28:
BUY October 14 puts, 1,457.50 strike, ask 23.40, add trading fees = $2,349
SELL October 21 puts, 1,455 strike, bid 24.70, less trading fees = ($2,461)
SELL October 28 puts, 1,455 strike, bid 29.50, less trading fees = ($2,941)
NET Credit = ($3,053)
The net credit from this installment sets up a diagonal ratio and an advantageous risk hedge. If either of the short puts are early exercised at 1,455 strike before October 14, the long put can be applied to set up a net profit of 2.5 points (1,457.50 – 1,455). The net credit provides a comfortable buffer.
Expecting the short-term bearish swing to occur, the long 1,457.50 put would become profitable before October 14 and can be closed. Ideally, you expect the swing to turn and remain above the short strikes of 1,455. The current price at the moment of this analysis was three points out of the money, so as long as the swing returns to this level or higher, both short puts will expire worthless.
If they move in the money, they can be rolled forward to avoid exercise. Because the net outcome was $3,089, you could roll to a lower strike and take a loss while further reducing the chances of exercise. As long as the loss is well below the level of the net credit, overall profitability is maintained. Alternatively, the positions can be closed at a small loss – again, as long as the loss is absorbed by the net credit initially created. A final defensive move would be to offset the short puts with new, later-expiring long puts with offsetting positions. This extends the diagonal ratio and covers the initial short position.
As expiration approaches for the initial shorts (22 days and 29 days), all of the time value will evaporate with accelerated decay. So the short positions are advantageous. Even if price moves against the shorts, taking them in the money, the ability to roll and replace adds great flexibility within the range of the net credit.