Annuities and Other Retirement Products: Designing the Payout Phase (Directions in Development)_5

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Annuities and Other Retirement Products: Designing the Payout Phase (Directions in Development)_5 O ne by two directional spreads 9 99  One of our clients was a a trader for a major hedge fund who got caught out on a put 1×2. He began to cover their risk by selling futures. Then the other players in the market needed to sell futures in order to cover their risk. The market went down and down. Traders were ringing us up, asking ‘What’s going on? This don’t make sense.’ Finally the spread-arbs stabi- lised the market, but our client had lost big, and he was furious. There were phone calls and meetings, but fortu- Either you work with nately it didn’t get ugly. In the end he forgave us an options strategist or our sins because he accepted that the broker made you stick to 1×1s, long an honest mistake. (Like not knowing what he vanillas, and butterflies was doing.) The lesson is: either you work with an or condors options strategist or you stick to 1×1s, long vanil- las, and butterflies or condors. 10 Combos and hybrid spreads for market direction Long call, short put combo or cylinder Bullish strategy Still another way of financing a long call position is to sell a put. Usually both strikes are out-of-the-money, and this spread is called the long call, short put combo. It is also called the cylinder. If Another way of financing XYZ is at 100, you may buy the 110 call and sell a long call position is the 85 put in the same transaction. In order to trade to sell a put this spread, you must be reasonably certain that the underlying is due to increase in value, because the short put incurs the potential obligation to buy the underlying. The downside risk is great, but so is the upside potential. This spread is often traded by professionals who want to buy the underly- ing. The long call serves as a buy-stop order, while the short put serves as a resting buy order where value is estimated to be. Consider the following: Coca-Cola at 52.67 60 days until August expiration Contract multiplier of $100 The August options are shown in Table 10.1. O ptions spreads 1 02 P art 2  Table 10.1 Coca-Cola August options 40.00 42.50 45.00 47.50 50.00 52.50 55.00 57.50 60.00 Strike 4.04 2.52 1.45 0.79 0.34 June calls 0.34 0.47 0.82 1.30 2.05 2.90 June puts Data courtesy of the Chicago Board Options Exchange, CBOE. Here, you could pay 0.79 for one August 57.50 call, and sell one August 45.00 put at 0.82 for a net credit of 0.03.1 On the upside, the spread behaves like a long 57.50 call sold for 0.03. The break-even level is the call strike price minus the cost of the spread, or 57.50 – 0.03 = 57.47. You are long a call, so you have unlimited upside potential. On the downside, the spread behaves like a short 45 put for which you receive a credit of 0.03. If at expiration, the stock closes below the put strike, or 45, you will be assigned on the short put, and you will be obli- gated to buy the stock at the strike price, or 45. The cost of your stock purchase will be effectively reduced by the credit of the spread. For exam- ple, if the stock closes at 45 and you are assigned on the put, the purchase price of Coca-Cola would be 45 – 0.03 = 44.97. If the stock continues to decline, you are still obligated to make purchase for an effective price of 44.97. Because of the naked, short put, the potential loss is large. It is advisable to place the put at a greater distance from the underlying than the call, unless you are convinced that the stock has bottomed out. Use the technicals to find a support area. If at expiration the stock closes between 45 and 57.50, the credit from the spread, or 0.03 in this case, is earned. The expiration profit/loss is summa- rised as follows: Debit from August 57.50 call: –0.79 Credit from August 45 put: 0.82 ––––– Total credit: 0.03 Because you have traded this spread for a credit, there is no upside break- even level ...