This is the fifth 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 was similar to Part 3, but involving speculation in puts. And this, the last part, Part 5, examines an expansion of these ideas with the use of straddles, strangles and synthetics as offsets.
The ultimate variation of an installment strategy expands potential strategies to create favorable outcomes. The flexibility of options trading allows this with specific techniques aimed at reducing overall risk while hedging long positions with shorter-term short positions.
The basic concept in installment strategies is to set up long positions and then pay for them with very short-term short positions. Time decay makes these low-risk and eases the process of paying for otherwise expensive options. To make this even more flexible, suppose that rather than opening single-option positions, a more aggressive version were used.
For example, a long straddle opened eight months in the future would be a very expensive position. However, it sets up potential profits as long as price movement is sufficient in either direction. This price movement is not needed, however, if those long-term long options are paid for over a series of short offsets.
For example, Alphabet (GOOG) closed on October 4 at $776.43 per share. The chart reveals that price has been in consolidation between $760 and $785 since early August. A dilemma you face in this situation is in trying to determine which direction price is likely to move next.
A long straddle certainly exploits any substantial movement, but the cost of setting this up is prohibitive in the long-term and has low probability of success in the short term. The installment strategy solves this problem.
A long straddle can be set up using the June 16, 2017 expirations (254 days). Close to the money positions were priced at the close of October 4 as follows:
775 call, ask 61.30, add trading fees, total cost = $6,139
775 put, ask 57.70, add trading fees, total cost = $5,779
Total debit = $11,918
The breakeven for this position has two prices, one above and one below the strike:
Upper breakeven: 775 + 119.18 = $894.18 per share
Lower breakeven 775 – 119.18 = $655.82 per share
This breakeven prices are far removed from the recent price range of GOOG, but not unrealistic. However, given the high cost, the position appears too risky given the cost. However, if this could be reduced to a zero net cost, then any movement above or below the 775 strike would represent a profitable outcome. With zero cost, the loss zone is reduced to zero.
In order to pay for this long straddle, a series of short positions are employed. This strategy required using two standard deviations from price to reduce risk, as well as focus on extremely short-term expirations to maximize time decay. The Bollinger Bands that are overlaid on the price chart shows that the current price was at the middle band, and that two standard deviations extended from a high of $789.35 to a low of $758.12.
Opening short-term short positions close to these two standard deviations is exceptionally low-risk. If price approaches either extreme, the short options can be closed or rolled to avoid exercise. The initial short positions based on October 14 expirations (9 days) are:
790 call, bid 2.50, less trading fees, net credit = $241
757.50 put, bid 2.15, less trading fees, net credit = $206
Net credit = $447
The total cost of the long straddle was $11,918, and the short-term short options yielded a credit of $447. By duplicating similar trades 27 times (or on average, once every 9.5 days), the long-term long options are reduced to a zero basis. Even if some net debit remains by the end of 254 days, a drastically reduced net cost would enable a profitable outcome for a relatively small span of price, meaning one side or the other would be profitable with very little price movement.
The need to repeat a trade such as this 27 times can be reduced substantially by employing options less than two standard deviations from price. For example, the 780 call (bid 5.90) and the 767.50 put (bid 4.30) produce a net credit of $1,002 ($590 + $430 -$18). Repeating this 12 times (or, once every 21 days) also achieves a zero net cost in the long straddle.