I read with interest Dr. Joe's explanation of the DLS strategy. I am wondering what group members with experience using this strategy would say in response to the cautionary notes I found in Lawrence McMillan's Options as a Strategic Investment. I apologize for posting such a lengthy excerpt, but it seems relevant and I would like to know what the group has to say about McMillan's analysis.
McMillan writes: "Many traders are fond of buying LEAPs and selling an out-of-the-money near-term call as a hedge. Be careful about doing this. If the underling common rises too fast and/or interest rates fall and/or volatility decreases, this could be a poor strategy. There is really nothing quite as psychologically damaging as being right about the stock, but being in the wrong option strategy and therefore losing money. Consider the above examples [buy XYZ LEAP @ 100; sell XYZ near-term call @ 110]. Ostensibly the spreader was bullish on XYZ; that's why he chose bull spreads. If XYZ became a wildly bullish stock and rose from 100 to 180 in three months, the diagonal spreader would have lost money. He couldn't have been happy -- no one would be. This is something to keep in mind when diagonalizing a LEAPS spread.
The deltas of the options involved int he spread will give one a good clue as to how it is going to perform. Recall that a short-term, in-the-money option acquires a rather high delta, especially as expiration draws nigh. However, an in-the-money LEAPS call will _not_ have an extremely high delta, because of the vast amount of time remaining. Thus, one is short an option with a high delta and long an option with a smaller delta. These deltas indicate that one is going to lose money if the underlying stock rises in price. Consider the following situation:
[table showing XYZ @ 120. Long 1 Jan LEAP @ 100, with a delta of 0.70. Short 1 April 110 call with a delta of -0.90.]
At this point if XYZ rises in price by 1 point, the spread can be expected to lose 20 cents, since the delta of the short option is 0.20 greater than the delta of the long option.
This phenomenon has ramifications for the diagonal spreader of LEAPS. If the two strike prices of the spread are too close together, it may actually be possible to construct a bull spread that _loses_ money on the upside. That would be very difficult for most traders to accept. In the above example, as depicted in table 25-4, that's what happens. One way around this is to widen the strike prices out so that there is at least some profit potential, even if the stock rises dramatically. That may be difficult to do and still be able to sell the short-term option for any meaningful amount of premium.
Note that a diagonal spread could even be considered as a substitute for a covered write in some special cases. It was shown that a LEAPS call can sometimes be used as a substitute for the common stock, with the investor placing the difference between athe cost of a LEAPS call and the cost of the stock in the bank (or in T-bills). Suppose that an investor is a covered writer, buying stock and selling relatively short-term calls against it. If that investor were to make a LEAPS call substitution for his stock, he would then hav ea diagonal bull spread. Such a diagonal spread would probably have less risk than the one described above, since the investor presumably chose the LEAPS substitution because it was "cheap." [I think he means because LEAPS are cheaper due to low volatility and low interest rates] Still, the potential pitfalls of the diagonal bull spread would apply to this situation as well. Thus if one is a covered writer, this does not necessarily mean that he can substitute LEAPS calls for the long stock without taking care. The resulting position may not resemble a covered write as much as he thought it would.
The bottom line is that if one pays a debit greater than the difference in the strike prices, he may eventually lose money if the stock rises far enough to virtually eliminate the time premium of both options. This comes into play also if one rolls his options _down_ if the underlying stock declines. Eventually, by doing so, he may _invert_ the strikes -- i.e. the striking price of the written option is lower than the striking price of the option that is owned. In _that_ case, he will have locked in a loss if the overall _credit_ he has received is less than the difference in the strikes -- a quite likely event. So, for those who think this strategy is akin to a guaranteed profit, think again. It most certainly is not."
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