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This is a level 2 question.
I have been paper trading an account for some months and there's something that confuses me. Say stock XYZ is trading at 207 today and the January 210 call is trading around $23. Isn't this free money? If I buy XYZ at 207 and immediately sell the January 210 call, where's the downside? If the stock appreciates, I make 100+ percent annualized. If the stock tanks, I keep the premium and roll down. Is my math wrong?
There is no such thing as a free lunch. What you are advocating is similar to an idea that caused pain back in the 1987 crash. Back then, people thought that portfolio insurance was free money. Portfolio insurance was a strategy used by portfolio managers to protect their stock portfolios against market declines. The flaw with that strategy was finally detected in fast-moving markets when specific levels that dictated immediate action were hit. At those price points index futures were to be sold to hedge the portfolio. When the market blew through those price levels, losses weren't contained as theory suggested; instead they actually increased. The losses widened because the market moved too far and too fast for the hedges to be properly placed (i.e. at the right price points and in the right quantities). This is similar to what you are advocating here.
This is not to say that your trade can't work, but you should understand all the risk that it contains. It is not a free lunch. Let's explain the risk in your trade. In theory, it sounds perfect. You buy XYZ and have a 23-point cushion. If it slowly goes down, you just roll down the call. You roll down the short call by buying it back and then selling another call with a lower strike price and pocket the new premium. You keep rolling down until eventually the market rallies and the call gets exercised. In theory, if it's a slow orderly decline the premium will protect you and will cover your losses on the long stock position.
However, what happens if the stock's decline isn't slow and orderly? What happens if the market for XYZ drops 60 points or more in a day? The call that you sold would come down in value and would be profitable to you. However, at best (assuming that all the value was written down even though some time remained) that would only provide 23 points of cushion. How are you going to recover the other 37 or more points of losses? You could sell another call, possibly the 140 call now for 25 points, but if XYZ went back up you would lock in a loss of (207 –140) – (23 + 25) = loss of 19 points or $1,900 per contract.
The above formula relates to the following option activity.
Purchased stock at 207
Sold a 140 call that was exercised thus sold stock at 140
Received 23 points premium from written 210 call
Received 25 points premium from written 140 call
In this particular case a quick downward move can lock you into a sizeable loss. Nevertheless, you can realize some pretty healthy returns that could justify taking this risk. But at least you now understand what the worst-case scenario looks like and can formulate a plan to adapt if needed. Good luck with your trading.
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Question Level Key
Level One--Basic Jargon, Definitions, Basic Mechanics of Trading.
Level Two--Introductory Points, Practical Points and Simple Strategies
Level Three--More Advanced Strategies and Repairs
Level Four--Risk Management, Psychology, and How Best to Evaluate Things.
Level Five--High end questions concerning Portfolio Analysis, Managing a Portfolio
of Options, Option Pricing Models, and Nuances of Trading. Included could be a variety of
other topics.
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