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Ask the Institute

DATE: December 17, 2001

QUESTION:
I am considering the following strategy: buying a LEAPS® put and selling the same strike or different for 1 -3 months. If the stock stays the same, it appears that a profit of about 25% can be realized. Even if the underlying moves, it is still possible make money. For example, I bought a 55 put for January 2003 for at 8.50, and sold a February 65 put at 4.75. If the underlying stays between 62 and 68, I may make 20 - 40% in one month. What is the downside to this strategy?


ANSWER:
Your analysis is very good as far as it goes, but you probably already know that when something sounds this good, there must be some additional risks.

You are absolutely correct that, if the underlying stays between 62 and 68, then the profit potential is impressive. However, you must look at other market movement scenarios and ask yourself if you are prepared for the risks.

First, suppose the underlying rises above 70. In this case, your short February 65 put will expire worthless, but your long January 2003 55 put will have declined in value, possibility by 4.5 or more. If this occurs, then you will have a realized profit on the expiring short put and an unrealized loss on the long put. It is possible that the combination of the two could be a net loss.

Second, there is the risk of early assignment on the short put, if your options are subject to American-style exercise. Consider the following scenario as an example of how this risk could result in a loss. Assume that the XYZ index is at 58.00 three days prior to February expiration, the February 65 put is trading at 7 and the January 2003 55 put is trading at 12. Your first reaction is that this is fair, because you have an unrealized loss of 2.25 on the short put and an unrealized profit of 3.50 on the long put. However, if the short put is assigned early and the XYZ index opens higher the next day and the January 2003 55 put opens lower, then you could be in a loss situation. If an early assignment occurs, then the short option position no longer exists and cannot, therefore, offset changes in a long option position.

How likely is any of these scenarios to occur? I do not know the answer to this question, but the options market seems to think that some chance exist, otherwise the options would be priced differently. In short, the potential profit you identified exists only because there is a risk of loss associated with it.


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