Riskless Collar (Part 2)

The saying is “no risk, no reward.” In the case of a guaranteed “MONSTER TRADE,” risk certainly abounds.

As another instance of potential pitfalls, consider the second example where I repurchase the stock at $150 after the first month and sell the 157.5 strike call for $300. Over the next 11 months, the stock falls back to the initial price of $100 thereby allowing all short calls to expire worthless. In this case, we have:

1.   -$1,200 to buy the initial long put
2. -$10,000 to purchase the initial stock
3.       $300 for the initial short call
4.  $10,500 for the initial stock sale
5. -$15,000 for the stock repurchase
6.    $3,300 for selling 11 monthly OTM calls
7.  $10,000 for the final stock sale

The total after one year is -$2,100 (-13% on -$16,200).

We fall short of making any money at all in these scenarios, much less making 50% annually. Note also that:

1. Transaction costs, which would lower returns, were left out of the consideration altogether.
2. Call premiums were dramatically exaggerated (by 50-100%), which has artificially boosted still-negative returns.
3. In the final scenario, I’m not even addressing the problematic implications of having to increase capital on the trade.

The fatal flaw in this trade design is to assume I can simply continue to sell OTM calls and generate revenue.

If the market hits the short call strike then we need to consider action. A further rally will cause the long put to lose money while stock gains are offset. I may be able to roll the short call out and up for additional credit and for a greater potential stock gain. I could consider selling the put to recapture remaining premium and repurchasing if the stock falls back near the original price. None of this protects from a big price gap, though, where I wouldn’t be able to escape profitably at all.

I found a similar article (advertisement?) in my archives from Dec 2007. In the spirit of this blog mini-series, let’s delve in.

     > Although I recommend simple, easy-to-execute trades in my
     > ChangeWave Options Trader service, I personally use a variety
     > of strategies to keep the profits coming and the losses limited.

I searched online for this newsletter/service. I was not surprised to see it no longer in existence.

     > …it’s hard for me to wrap my head around the idea that a lot of
     > people want to shy away from trading puts. After all, using put
     > options to protect… stock… is like purchasing… life insurance…
     >
     > I’ve heard folks grouse that they “wasted…” money on a protective
     > put because the stock didn’t go down. Huh?! It’s not like you buy
     > a life insurance policy and say, “Damn! I didn’t die and get to
     > cash it in!” You should just be glad that you had the protection
     > in place and didn’t need it!

That’s a compelling argument—and funny too! Remember what I said about humor…