Riskless Collar (Part 1)

I want to alter course for the day and pick apart a “perfect trade” I recently stumbled upon.

The post reads something like this (cleaned up for grammatical errors):

     > There are a lot of stock options trading strategies that have
     > been used by hedge funds and successful traders but the question
     > is just how conservative do we want to be?
     >
     > I call my favorite strategy ever the MONSTER TRADE because it
     > can’t lose at all and your profit margin is 50% per year.

Guarantees are illegal in the financial industry (probably because no real guarantees exist!). This is a gigantic red flag. A perfectly appropriate course of action would be to run for the hills without doing any further investigation. I continue because I am interested in figuring out puzzles and in learning about how the industry works (for better or for worse).

     > The strategy is based on purchasing 100 shares of stock,
     > selling monthly call options for one year or less, and
     > concomitantly buying a one-year put option as a hedge.
     >
     > For example, buy 100 shares of XYZ for $50/share. Sell
     > one monthly call OTM to collect $100. Repeat this 12 times
     > to collect $1,200. Purchase the one-year $50-strike put
     > option for $400. Your annual income will be $800
     > regardless of whether the stock goes up or down.

Supposing this were all true, $800 / ($50 * 100) = 16% annualized. What happened to the 50% mentioned above?

Let’s consider another potential pitfall given stock price of $100 and IV at 30% with interest rates and dividends set to zero. A one-year ATM put will now cost around $1,200.

Suppose I sell a monthly 105 call for $300 [theoretical value $150]. The very next day, stock crashes to $70 and trades roughly sideways for the month. The short call expires worthless.

With IV now up to 50%, I sell a second monthly call at the 73.5 strike (5% OTM) for $300 [theoretical value $200]. Stock rebounds to $100 the very next day and trades sideways. The short call gets assigned and I sell stock for $73.50/share. Assuming IV falls to 40%, the put with 10 months to expiration is now worth $1,400. Since the stock will go straight up for the rest of the year (future leak), I sell it now for the best price possible.

What do we have in this “can’t lose” trade?

1.   -$1,200 to buy the initial long put
2. -$10,000 to purchase the initial stock
3.       $600 for the two calls sold
4.    $7,350 for the stock sale
5.    $1,400 for the put sale

         ———————————————–
          -$1,850 (-15.4% annualized)

As a second example, consider the same situation where the stock gaps overnight to $150 and gets assigned at $105/share for a $500 stock profit in addition to $300 call premium. The put, [virtually] worthless now, leaves me with a $400 loss.

Oh for two…

I will continue next time.