Been doing some long Leaps calls and shorting front month, decent but unspectacular returns. I did have a mini-blow up on one stock (GS), however. What s the best way to protect the downside on a Leap calender call? Stops? How to pick the right price or percentage? Take the call income into consideration? Make them trailing?
I'd suggest using long legs of mid term duration instead of LEAPS (4-9 months). Since they cost less, blow ups should be less painful. Yes, they cost a bit more per day but that's not that significant compared to the blow up cost. And if your short term writing is successful, you can roll them out every coupla months.
The decay characteristics on being short the front months and long the leaps is favorable - don't do anything to that. If you are net long deltas from this position, or a graph of your position shows more downside vulnerability than you want, short stock until you are satisfied with your returns at each possible future price point.
But doesn't adding short stock as a hedge for the long Leap call / short OTM call trade increase the cost of the trade -- and thus the return -- significantly. And if the stock gaps up? You are long one position and short two.
Spin! Yes a SPINDRO answer and one that I've seen many times. Good to see you - er - well in cyber space I mean. Don't forget the calendar has upside risk. Hedge the downside means increasing upside risk. The short stock answer assumed that the calendar was already net long deltas - and so shorting enough stock to neutralize. Yes, if the stock gapped up significant losses are possible - which is why you'd want to manage it closely. Assuming a neutral calendar - only neutral positions can keep it neutral. It's difficult - long straddle would protect against large moves - size of straddle and management of now somewhat unweildy position might not be fun. Compare diagonals to your calendar and see how you might manage those.
But back to my original question: How much danger using stop losses with Leaps? Am I going to get plucked off early and unfairly?
I doubt that stops would work well with options - you'd probably get ripped off. I've never tried using stops with options - never seemed like a good idea - although it would might work well enough with QQQQ and possibly other very liquid penny increment options - still you may run the risk of being ripped off because liquidity varies during the day and as options move away from ATM. Another management strategy would be to sell part of long side if you can carry the naked shorts. You'd be taking a loss, but could make it up through time decay, favorable underlying moves and roll outs. Once again you'd be increasing upside risk.
Stops may be useful but I'm not a fan of them because sometimes the B/A spreads get kinda wide and that may trigger them. Plus there's no guarantee that your stop will get filled at a reasonable price if a fast market blows through your price. If the stock is dropping, the first thing that I would do is evaluate why. If it's not nasty individual stock news and the outlook is still viable, I'd consider adjustment possibilities. Maybe roll. Maybe add overwrite a little or short some stock. But bear in mind that no matter what you do, there's always a scenario where things get worse. As per my previous reply, I think that using mid term options for the long leg is a better idea. Less money is at risk should the underlying tank plus longer term options are more susceptible to IV changes. Yes, that's a double edged sword - it can help you as well. An '09 or '10 LEAP can lose twice the premium of a 4 month (same strike) with only a 5 BP loss in IV. Any way you cut it, you have risk and need to have a plan in place before you take the position. That's no guarantee of success but it's more likely that you'll survive if you react versus standing there like a deer in the headlights when the bottom falls out.