Take SPY as the obvious example. Mar 18 2022 400 call = $59.70, SPY price = $452.30. $52.30 of intrinsic value, $7.40 of extrinsic value. The extrinsic value is 12.4% of the option price; this is the price of your insurance. Over 2 months, let's say SPY moves up by $20 to $472.50. The call is now $72.30 ITM. The Jan 21 2022 380 call is the proxy for your 400 call after two months. The 380 call is worth $75.60; $72.30 = intrinsic value, $3.30 = extrinsic value. So in other words, you capture the $20 upside in SPY, and lose $4.10 of the original extrinsic value. You are $4.10 behind a long stock position (though you only spent 13.1% of the cost of buying 100 shares) Let's now say that SPY falls by $50 over two months. The 400 call is only $2.30 ITM. The Jan 21 2022 450 call is the proxy for your 400 call after two months. It is worth $14.79; $2.30 in intrinsic value, $12.49 of extrinsic value. If you were long stock, you were down $50. If you own the 400 call, you are only down $44.91. Let's go further and model a real correction; SPY falls $100 over two months. The Jan 21 2022 500 call is the proxy for the 400 call. It is only worth 35 cents, so essentially zero. Your option position loses $59.70-$0.35 = $59.35. If you owned 100 shares of stock, you lost $100. Obviously, my calculations assume that IV is unchanged, and that's not going to be true in practice. Honestly, IV is pretty low right now, so in the event of a downturn, it's going to rise, and it will provide a little upside "kick" to your long option. So to summarize: SPY + $20 => You lose $4.10 of upside relative to owning shares SPY - $50 => You lose $5.09 less relative to owning shares SPY - $100 => You lose $40.65 less relative to owning shares Does this all make sense? Is this the kind of "insurance" that you were looking for from options?
I wouldn't bother reading it if I was you. If it's coming out of my keyboard, it probably ranges between Crap and outright disinformation . Technically-correct-but-uninsightful is a stretch goal
@morganpbrown, thx for the detailed example. But it uses a DTE of just 5 months, right? It gets costly doing this for the said whole year (cf. OP), isn't it? Another problem is how to calculate the percentage loss: ie. if the Call expires worthless, then what is your loss in percentage? IMO it's 100% loss. But we wanted to limit the loss to 5%. How much is it according to your calculation? But I must admit that I haven't grasped yet the role of the said proxy strike... Does it mean buying another Call? In the initial posting of this thread a stock position had to be protected/insured, but then you offered a solution w/o the stock, by using just a Long ITM Call option. Just reminding how we got here.
Read the guru's thread. He already leaked many many option strategies without any losses that are always profitable from inception.
The "proxy option" is not a profound concept; just a quick way to model an option's price as time passes and the underlying price changes. Say you own an option with 120 DTE that is $50 ITM. What will that option be worth with 90 DTE if the underlying moves up $20? You could a) model it with Black-Scholes, or b) look at an option - today - with 90 DTE that is $70 ITM. b) is the "proxy option".
I learned this a while back from a convo with a former floor trader. His boss would literally slap him on the head when he was trying to calculate the premium for up/down moves and go "duh, LOOK AT THE CHAIN." I'm told it didn't take more than a couple of smacks for him to get it...
Well, this is my pat on the back for the day: I actually do something that real trader would consider common sense. Maybe this is going to work out...or maybe it's not!
My understanding is that an option is an insurance. So it is worthwhile to imagine options in practice to understand them.