newbie needs a critique

Discussion in 'Options' started by blackjack, Jul 1, 2001.

  1. I forgot to notice that a big chink in the above scenario would be that you would need twice the capital to gain the same return.

    So, instead of getting, say $500 in premiums on $5K of XYZ long, you would be getting $500 in premiums on $10K of XYZ ($5K long and $5k short), which would cut your ROI in half.

    Your friendly neighborhood theory lynch mob member,


    #11     Jul 2, 2001
  2. Blackjack,
    Going long 100 shares in one account and short 100 in another account makes no sense as you effectively have no position. Profits in one account will be exactly offset by losses in the other account.

    Anyway, to help you understand, let's run through a simple scenario using the system you outlined.

    Assume you sold a 55 call when XYZ was at 50. It then trades to 100 and you are exercised. The shares you bought at 50 (account A) are sold at 55, so you make $5 per share plus the option premium. You now have to buy back the shares you sold short in account B at the current price of $100, so you lost $50 per share on these. Overall, you lose $40+ on this trade.

    This trade has unlimited losses if the share rises, and a limited profit if it stays below $55.

    The flaw in your strategy is that when you are exercised you have to sell your shares at the strike price of the option, not the current market price.
    #12     Jul 2, 2001
  3. def

    def Sponsor

    There is no holy grail with options - trust me, i've been trading them in some shape or form for over 15 years.

    you can increase your return by selling covered calls but you need to be aware of the risks.

    Try things out on paper for a couple of months and if you are serious about options, try reading Option Pricing and Volatility by Sheldon Natenburg. It is a textbook but well worth the read.
    #13     Jul 2, 2001
  4. blackjack,

    With respect to your latest strategy, it seems you're not quite getting the distinction between shorting a stock and simply selling. A short is nothing more than the sale of a stock--period. The only difference between that and selling a stock that you already own is that one is a sell to open order and one is a sell to close. This applies to your query because if you buy a stock and then "short" the same stock, you're not really shorting it, you're simply closing your long position. So in your strategy you outlined, you bought a stock, sold a covered call on it, and "shorted" the stock. But since your stock purchase and "short" cancel each other out giving you no stock position, all your play really is is a naked call.
    #14     Jul 2, 2001
  5. Let me try to lay out the scenario one more time. It doesn't seem like I communicated my idea clearly, though I am also very aware that I am new at this, and it is very possible I'm not hearing your answers clearly.


    Here is the idea, restated:

    1) Buy 100 shares XYZ at 50 in one brokerage account.

    2) Short sell 100 shares XYZ at 50 in another brokerage account.

    At this point, no matter what happens to the share price, you break even (minus commissions) because whatever you lose on one position you will make on the other.

    Why would you want to take on a short and long position at the same time?

    Reason: so you can sell a covered call on the long position without giving a darn whether the stock hits the strike price or beyond or tanks to zero.


    Smaple scenarios:

    Scenario One:

    Stock goes from $50 a share to $1 a share. On the expiration date, the stock is trading for $1 a share. You close out your short and long positions. You gain $49 a share on the short position, You lose $49 a share on the long position. Your net gain/loss on the stock transactions is zero. However, you get to keep your covered call option premium (minus commissions). You are happy.

    Scenario Two:

    Stock goes from $50 a share to the strike price of, say, $55. You close out your short position, using a buy stop, at $55. You lose $5 a share on your short position. The buyer of the option pays you $55 for your long position. You make $5/share on your long position. Your net gain/loss on the stock transactions is zero. However, you make your covered call option premium (minus commissions). You are happy.

    Scenario Three:

    Stock goes from $50 a share to $100/share. The instant the stock hits $55 a share, you close out your short position with a buy stop order. You lose $5/share on your short position. At some time before or at the expiration date, you sell your long position to the option holder for $55 a share. You make $5/share on your long position. Your net gain/loss on the stock transactions is zero. However, you make your covered call option premium (minus commissions). You are happy. (As long as you can not feel bad that the stock went to $100/share--but your goal here is covered call premiums, not stock profits.)


    It seems to me that in all of the above scenarios, the outcome is the same: Your short and long positions cancel out, and you make a covered call premium, minus commissions.


    Gotta be something I am missing...?

    Thanks for putting up with my newbieness,

    #15     Jul 2, 2001
  6. I neglected to mention that my previous post was based on selling out-of-the-money covered calls, not in-the-money covered calls.

    #16     Jul 2, 2001
  7. Babak


    Here's what you're missing in your strategy:

    1]margin for the short position (cash drag would reduce your yield/return)

    2]possibility that stock peek-a-boos above your stop price ($55) and then heads down.What do you do? reestablish the short? at what price?

    3]this is a rather cumbersome/clunky way to get protection to downside. Someone already mentioned the collar in this thread (sell call buy put). That is a more elegant method of protecting the downside.

    4]you are not evaluating option volatility and how it effects your strategy when it is as important (and sometimes more important) than the direction of the underlying security.

    Excluding war, financial market are the most brutal environment that mankind has created. Find a good book on options and learn the greeks. Arm yourself with knowledge.

    Or if you want to leave it to the professionals, there are many mutual funds out there that do exactly this (covered call write) and have a nice built in cushion through the yield they throw off.
    #17     Jul 2, 2001
  8. def

    def Sponsor

    you are missing one other scenario:

    Company X announces steller earnings. Stock gaps up $20.
    You will not be able to stop out at $55. You gain $5 + premium on the long stock short call. You lose $20+ on the short stock.

    You will then probably get a margin call on the short stock and be forced to liquidate (if you are with IB you will not get a call and the system will liquidate) at a loss that could wipe out your account.

    You also are assuming you will get assigned when the stock goes through the strike price (your stop loss strategy). In reality, you will not get assigned until expiration day or the before the stock goes ex-div.
    #18     Jul 2, 2001
  9. Blackjack,

    The main reasons your situation is not advisable is that as you mentioned it ties up double the amount of money for one position, and for a relatively tiny return (the only profit potential here is the covered call premium). In addition, you're looking at having to have two separate accounts open just to execute one trading plan, which is extremely cumbersome.

    As def pointed out, the other chink in the armor is if the stock gaps or moves above your strike price and you are unable to close your short position. In this case your covered call acts as the ceiling on your long position, which in this case no longer cancels out the short position, leaving you exposed.

    Believe all of us when we tell you that there is no sure thing in the markets and no foolproof money making strategy. If there were, we'd all be rich. Every play brings with it a certain amount of risk. However, I again stress that for the kind of plays you're proposing, your best bet and lowest risk play is the collar.
    #19     Jul 3, 2001
  10. dozu888


    Why waste so many keystrokes. One sentence: There is no free lunch on Wall Street.

    Whatever 'smart' ideas you just invented, there have been thousands of people thought about the same thing.
    #20     Aug 4, 2001