I’ve been asked a couple of times by members why we have used two different methods, hedged puts on our IBM trade but LEAPs on our recent UNP trade. Both rationales seemed the same: exploit a boring but rising stock over the long term. But we used one method from IBM (selling puts against a long term OTM put) and a different one for UNP (long a LEAP call and then sell monthly OTM calls against it). Why the different approaches?
The short answer is to show the two ways of trading these set ups. I use both as I like having short calls and puts in my portfolio to cancel out any market risk. But if I was to choose which one would I use? Well they both have their advantages and disadvantages:
- Is more similar to covered call than hedged puts
- At end of process we won something: the deep ITM call
- No margin requirements
- Hard to manage though if we are ‘too’ right. A sharp upward move leaves us managing short near month options which are ITM (if we continue to be right they will move well into the money with little time value)
- This provides an easier to manage set up
- Should the stock move in the direction we want, the options will move out of the money and we can sell another set of puts in the next month
- If the stock moves down, and the puts expire ITM we are less concerned with rolling at the same strike price to the next month; we expect the stock to be higher sometime in the future.
- However large margin requirements
- And we don’t own anything at the end (no deep ITM option). We only receive our margin back.
As you can see there are reasons for against either position. However if I was to choose one, particularly if I was a beginner, I would pick the LEAP call method. Should our short option move deep in the money (10-15%) I would probably take the position off.
Hope this helps.