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This is a level 2 question.
I bought ABC stock at $15, then simultaneously traded 2 LEAPS, long-term options that expire the year after next. I sold a call with a strike price of 20 and bought a put with a strike of 15. The money I received for the call paid for the put, so the options cost me nothing. At the end of two years, if the stock is $15 or below I lose nothing, yet the profit between $15 and $20 is all mine. Is this a sound strategy?
The soundness of this strategy depends on what you're looking for. In this case, it sounds as if low risk is your primary concern. Your assessment of this position's profit profile is accurate. Buying the put affords you downside protection in case the stock price slides below $15 over the next two years. Financing the put purchase by selling a call (a covered call, in effect) limits the upside potential to the strike price of the call. Thus, your cash at risk is limited to the $15 paid for the stock. In general, this assumes that you can in fact cover your put purchase after all costs (commissions) are taken into account.
Let's see what happens to this position at different stock prices at expiration. If ABC finishes below $15, the sold call expires worthless and the drop in stock price is effectively negated by the put. Therefore, the position breaks even (minus commissions, of course).
If the stock finishes above $20, the put expires worthless, and the call will likely be exercised, meaning that you would forfeit any gains above the strike price. The gain on the position would thus be $5 on the stock. However, as with all covered call positions, you lost out on the stock price appreciation because your upside potential was capped by the sold call. If the stock finishes between $15 and $20, both the put and call expire worthless and you gain the amount the stock closes above $15.
I said above that this is a good strategy if you're looking for a low-risk, low-return investment. The bottom line is that you can't lose any money with this position (other than commissions and slippage). If you're looking for safety, then it is a smart move.
Remember, however, that you are tying up money for 2 years with a limited return (maximum of 33 percent). You must also keep in mind that this example assumes that the call sale completely covered the put purchase and that the overall profitability will be affected by commission costs. Finally, as with all options strategies, the key factor is your assessment of the direction and speed of movement of the underlying stock.
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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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