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Post by chiu on May 22, 2006 6:16:42 GMT -4
One seasoned trader have this strategy.
As buying outright call and put loses will have time delay. There is one way out.
First you would calculate how much that the option will decay in the next month. A quick and easy way to do this would be to look at the option chain for the stock, and see what that same strike option sells for a shorter-term month. For example, if were thinking about buying a Sep 60 Call for $2.6, you could look at the Jun 60 call, and see that it is selling for $2.0. Since there are three months between Sep and Jun, if the stock price stays the same, this option will decay by $0.2 each month.
Another way to figure how much the call will decay if the stock stays flat is to divide the time premium by the number or remaining months. You will get a higher number than the above calculation because the greatest monthly decay will occur as the options approach expiration.
The next step is to figure out how many short-term (next expiration month) options you would need to sell in order to recoup the $0.50 per option decay that will occur in the next month.
If you had bought 10 Sep 60 Calls and will therefore lose $200 in decay next month, you would have to sell at least $200 worth of next-month 60 Calls. If those calls are selling for $1.00, you would only have to sell 2 of them to get back the money you will lose in the decay of the 10 Sep 60 call you own.
So your position becomes Buy 10 Sep $60 Call Sell 2 Jun $60 Call instead of just buying 10 Sep $60 Call outright.
The catch of this strategy is you need to be a relative size player to implement the strategy.
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kareen
Trader
Pattern Trader Batch 04
Er Fish...
Posts: 14
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Post by kareen on Jun 26, 2006 13:01:42 GMT -4
veri chim.... can explain a little more details?
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Post by He Shuhan on Jun 26, 2006 14:39:59 GMT -4
Dear Kareen and all,
Let me first give a simplified understanding of what he's trying to share here:
1. When you buy an option, you will incur time decay.
2. On one hand, you want the unlimited profit potential of a straight call or put; but on the other hand, you don't want to incur (or at least attempt to reduce) on time decay.
3. So you buy a further month option, for example, 3 months from now.
4. And then you calculate the theoretical value in which time decay occurs for this particular set of options. If a September call cost $2, and a June Call cost you $1.40, the time decay would therfore be ($2.00 - $1.40) / 3 = $0.20 per month; for each contract you bought.
5. So to compensate for that, you sell options that can give you at least $0.20 per month to cover up for the time decay loss.
Comment: This strategy is probably more effective if you can use a option analyser to factor in volatility impact. As option prices includes not only the intrinsic value and the time value, implied volatility has to be factored in as well - but that may not be straightforward and easy to do. Shorting will also required a large amount of margin (deposit) retained by your broker for insurance purposes, thus making this strategy significantly less effective for the average players out there.
Hope it clears the question you have.
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Post by Donnie Tay on Jun 27, 2006 3:48:57 GMT -4
Chiu's method is a quick an easy way to estimate time decay.
Performing a linear interpolation for time decay values is inaccurate, as time decay is an exponential function, and eroding effects is significant at expiry months.
Cheers !!!
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kareen
Trader
Pattern Trader Batch 04
Er Fish...
Posts: 14
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Post by kareen on Jun 27, 2006 11:52:44 GMT -4
hm... I think I understand a little bit more but why u need to be a sizeable player to play this strategy? Is it because of the CASH account thingy that is limiting u?
To me, I think when one employ this strategy, u r bullish or bearish on a longer term and this means one will propbably not going to get out of the trade within a day....
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Post by He Shuhan on Jun 27, 2006 13:56:05 GMT -4
Dear Kareen,
This strategy is known as a calendar ratio spread whereby you sell more legs than you buy them.
When you sell a leg without a hedge through options or stocks, you are considered selling naked. Ie. Shorting.
You'd probably have heard that selling naked can be extremely risky. Well brokerages recognise that too. In order to compensate for the amount of risk taken, a shorter will have to place a huge amount of margin as insurance deposit with them to execute the trade.
Let's do a simplfied example of how shorting can eat up your margin. Now imagine that Donnie is the one executing the trade. He buys 10 XYZ Aug 60 call, and sell 20 XYZ June 60 to compensate for the time decay loss. Since he now has 10 (20-10) more uncovered sold options, he is considered to have shorted 10 contracts. For that, he will need to put in a huge amount of cash, say, $50k to hold the position, until he closes it.
So let's assume your proposition that Donnie is bullish on XYZ for the next 3 months or so, and he has no intention to sell in within a day. Immediately when he executes this trade, his account will be have a debit of $50k. If he doesn't have that amount of money, he will loan it from the broker for a interest rate of 2% per month, which adds on to slippage cost. As long as he holds the position, for the next 3 months, he cannot buy anything new, do repair strategy or open new spreads until he tops up his account with at least $50k. In addition, no matter what happens, he will incur the 2% interest rate even if he makes a loss from the position.
The lockup period will only end when he closes the position.
Also, he cannot do such a trade if he has a small cash account, which by US regulatory is anything less than $200k. He can do it through a margin loan though, but he will incur on the interest charged.
Alas, locking up the $50k for a single trade will invariably eat into opportunity capital, which is only 1 of the 4 capitals he will bite into when he opens such a trade.
Hope it clears some doubts.
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kareen
Trader
Pattern Trader Batch 04
Er Fish...
Posts: 14
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Post by kareen on Jun 27, 2006 14:05:26 GMT -4
This is what chiu wrote : "
If you had bought 10 Sep 60 Calls and will therefore lose $200 in decay next month, you would have to sell at least $200 worth of next-month 60 Calls. If those calls are selling for $1.00, you would only have to sell 2 of them to get back the money you will lose in the decay of the 10 Sep 60 call you own.
So your position becomes Buy 10 Sep $60 Call Sell 2 Jun $60 Call instead of just buying 10 Sep $60 Call outright. "
This is what u wrote :" He buys 10 XYZ Aug 60 call, and sell 20 XYZ June 60 to compensate for the time decay loss. "
The two situation does not match.... I do not see a nake position in Chiu case....
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kareen
Trader
Pattern Trader Batch 04
Er Fish...
Posts: 14
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Post by kareen on Jun 27, 2006 14:06:48 GMT -4
I see that in Chiu case the 2 sell is a hedge position whereas your case is 10 nake position.....
PS: Ai-yo no need to so formal leh....
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Post by He Shuhan on Jun 27, 2006 14:52:37 GMT -4
Dear Kareen,
Yes the situation is not the same. Whiles I used a extreme example of Ratio Spread to illustrate my point, Chiu's case was the Backspread. The point I'm trying to drive is really the idea that whenever you sell an option you will need to deposit margin. In chiu's case, selling 2 options would have required a few hundred bucks as deposit. Of course, if it was naked it will be even more.
Another point I am driving at is that we should always measure the marginal benefits of whether to have a sold leg in the first place at all. If we had to risk $500 as margin to get the $200 time decay, then that might not be an exact wise choice.
In the thread under "Ratio and Backspread esssentials", I pointed out some benefits sand disadvantages of both strategies. In the thread, I explained that the problem of spreads is that it can easily turn into alligators when sudden volatility surprises, which is quite common, wipe out the carefully planned and cross-compensated trade.
Using Chiu's example, since he holds 10 long legs and 2 short legs, the chances that volatility surprises will wipe the trade out is pretty high (arithmetically though) - to the point of nullifying the 2 short leg's compensations.
Sorry for the wrong phrasing though. I reckon that should have phrased "The strategy I'm going to illustrate is....".
P.S. I answered in a formal way because I respect the question and I take pride in answering them to the best of my knowledge, as accurate and as responsibly as I can. By the way, I love the photo of your kid. It's cute!
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kareen
Trader
Pattern Trader Batch 04
Er Fish...
Posts: 14
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Post by kareen on Jun 28, 2006 13:45:44 GMT -4
In a $5 spread, ones get $2 credit for the time decay sounds like a good deal..... of course there are more than just the $ collected to take into consideration.... Thank you for pointing out the ratio and back spread differences. As I am not well verse in that I'm going to stick with simple stuff.... Currently, I'm only interested in how not to lose to time decay... Can I safely say that as long as I have enough margin in my IB account, it means that I am able to employ Chiu's straetegy to minimize time decay when I'm confident of the outlook with a longer time span? What I do not understand is his quote As for I think precise is not an issue here 'cos ultimately, u still want the BOT leg to earn $$, SOLD leg is only some sort of a little insurance to guard against the time decay..... PS: The avatar is my little angel in her earlier days....
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