Low Risk, 77% Annualized Return?

[MJ DeMarco]

So, instead of buying 2,000 shares which would cost $32,000, I’m attempting to show you could get the synthetic equivalent for much less. You could have the exposure of 2,000 shares by buying 40 call contracts of the PWE JUN09 15 strike. Those contracts would only cost you $11,800. You get the exposure of 2,000 shares, for about 1/3 the cost.

This is why I've always loved options ... leverage + control ... all for less than buying the stock.

 

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[AroundTheWorld]

You’ve seen first hand that i’m not a real good teacher. If you can point out where I’m rambling, I’ll narrow down and give the explanation another shot.

I had a professor in college that described four levels of knowledge.

Unconsciously Incompetent. You don't know what you don't know.
Consciously Incompetent. You know what you don't know.
Consciously Competent. You know it, but it has to be on a "conscious" level
Unconsciously Competent. You know it so well, you don't have to even "think" about it.

You, Edge, are Unconsciously Competent. I am Consciously Incompetent. For you the concepts are so integrated into your knowledge that you forget that other people don't know everything you know!! My hat is off to you.

What I don't get is this.... when you are doing a calendar spread, why use the same strike price?

 

[Edge]

What I don't get is this.... when you are doing a calendar spread, why use the same strike price?

By definition that is what a calendar spread is.

Can you sell a different strike? Absolutely, this is what is referred to as a diagonal spread. I do trade diagonal spreads, and I have also been known to roll a calendar into a diagonal spread.

You need to understand that you are taking on a different risk profile by doing so. If you break down the components of a diagonal spread, you’ll see that it is actually the combination of a calendar spread and a vertical spread. It is that embedded vertical spread that brings more risk to the position. It is also going to give you more credit, which is why you are probably asking the question.

In our example, the diagonal spread would be short Dec 12.5 strike and long Jun09 15 strike. This is really the sum of a calendar spread (short Dec08 15 strike and long Jan09 15 strike) and a vertical spread (short Nov 12.5 and long Nov 15 strike). Note when you do sum these components up, the short Nov08 15 strike out of the calendar and the long Nov08 15 strike out of the vertical cancel each other out. This leaves you with the diagonal. I know that was a little wordy, but I wanted to prove that there is an embedded vertical spread that brings on more risk to the position.

With calendar spreads, you can’t lose more than the original cost of the position. With diagonal spreads you can lose a lot more than the original cost of the position because of the risk profile of that embedded vertical.

I've attached the P&L charts for a calendar (top pic) and diagonal spread (bottom pic) below. A picture is worth a 1,000 words.

 

[kidgas]

Looks like the Nov 15 put would have been valuable.

 

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[NerdSmasher]

Hey Edge, what software is that?

 

[Edge]

Hey Edge, what software is that?

Thinkorswim.

 

[AroundTheWorld]

so.... lemme see if I have this right.

you would consider a calendar spread if you expect the price to stay flat and a diagonal spread if you are bullish ???

 

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[Edge]

so.... lemme see if I have this right.

you would consider a calendar spread if you expect the price to stay flat and a diagonal spread if you are bullish ???

No, a calendar or diagonal isn't bullish or bearish just becuase it is a calendar or diagonal. These spreads can be traded with a bullish, bearish, or neutral bias. It is the selection of strike price that makes it bullish or bearish.

General rule is that you want the market to go towards your short strike at expiration.

 

[Edge]

We've gone from Nov08 option expiry to Dec08 option expiry so it's probably time for an update.

First of all, I broke one of my rules getting into this position, and felt some pain becuase of it. I like to trade options on issues where the underlying is priced above $40/share and very liquid (meaning lots of volume in the underlying and option contracts). I felt some pain becuause there were times where I wanted to roll my short strike for between $0.30 and $0.40, but because of lack of volume I couldn't get filled. So there is a real example of why you hear me talking about trading liquid products.

What I ended up doing is rolling half of my position on 11/13 for $0.20, and I let the other half expire worthless and sold the Dec08 for $0.20. So the net of that is I rolled my Nov08 to Dec08 for $0.20.

My net risk in the position has decreased from $0.68/share to $0.48/share and I still have 3 more rolling opportunities. I still think this position has the potential to be a big winner (consistent with the title of this thread) and plan on riding it out through March. However, if SLW trades below the recent lows of $2.50/share, i'll take another hard look at this position and consider closing it out.

Well, since the title of this thread is 77% returns, I just thought i'd point out that I could close this position this morning for a profit of 77%. I am not closing it out, just thought i'd point that out for those following along.

So, yes, 77% returns are possible in this market.