One correction: there is 97 days to expiration not 100 days. not a big difference in the calculations.
Second, we need to factor theta in our return calculations. The profit/loss table from poweropt does factor it in. It shows a profit of $2769 at expiration for no change in IWM. That is with $25,696 of the leaps. Poweropt takes the premiums received and subtracts the theta decay of the leap to determine profit or loss. They use the Black-Scholes pricing to calculate the value of the leap at the various prices.
They calculate that if there is no change in IWM at short call expiration, ie $69.56 the profit would be $2769
The return would be 2769/25696 or 10.78% or 40.6% annualized.
You hear even the professional traders and website gurus that diagonal spreads are dangerous if the stock shoots up in price beyond the short call strike. Is that really true if you set up the position the way I do? Let's see
If IWM increases 15% from $69.56 to $80.00, per table from poweropt our position gains $3922 and that factors in theta loss of our leaps. Well 3922/25696 is 15.26% even greater than the 15% rise in IWM. This is because we received $3825 in short call premiums and the theta decay was not near that amount and our uncovered leaps appreciated in value.
Even with a rise of IWM to $100 or a 43.8% increase (highly unlikely) our positions profit will be $6789 or 26.4%.
Poweropts calculations (and i have a spreadsheet that closely approximates poweropts) assumes the same implied volatility at expiration. These would change the returns but not significantly because only the time value of the leaps are effected. With our DITM leaps there is little time value.
POINT: there is NO upside risk as many websites claim in the way I setup up our dls positions.PROFIT/LOSS AT SHORT CALL EXPIRATION 8/21/2010
The first table is our position of 9:11 sc:leap contracts
The second table demonstrates that even with 11:11 ratio position at expiration
or even if assigned early will not lose money. That is because our difference
in strike prices of leap and short call is greater than our net debit. This
table is from poweropt website.
This is our position selling 9:11 contract ratio
Price Profit/Loss
$30.00 ($21,024)
$40.00 ($18,241)
$50.00 ($12,994)
$60.00 ($5,635)
$69.56 $2,769
$70.00 $3,176
$80.00 $3,922
$90.00 $5,196
$100.00 $6,789
Notice how with this ratio we will participate in some of the capital gains of
IWM, even if IWM goes to $1000.00.
This is if we did 11:11 contract ratio
Price Profit/Loss
$30.00 ($20,174)
$40.00 ($17,391)
$50.00 ($12,144)
$60.00 ($4,785)
$69.56 $3,619
$70.00 $4,026
$80.00 $2,772
$90.00 $2,046
$100.00 $1,639
Notice how with a 11:11 ratio the p/l decreases but will never go below zero.
It will never go below the difference between strikes minus net debit times 1100
shares or (20-19.88)*1100 or $132.
--- In ConservativeOptionStrategies@yahoogroups.com, "joe & leigh" <gass20@...> wrote:
>
> DLS-PAPER TRADE #4
>
> CONTINUATION
>
> Our Initial Position:
>
> Starting Cash = $200,000
>
> 11 Jan12-50 strike leap @($25,696)
> 9 Aug10-70 strike short calls @$3,825
> Cost basis per leap share @($19.88)
> DLS cash account = $174,304
> $52,912 for rolling out leaps
> $122,012 for additional leap purchases when needed
> DSP = 14.9% (3,825/25,696)
>
> Additional points,
>
> 1) a 10% correction would have a loss of $20,000 (10%*$200,000) on buy-hold
> 2) same 10% would decrease our leap $5.84 (see above for explanation). That $5.84 times 1100 shares is $6,424. That is a 3.2% loss of portfolio (6,424/200,000)
> 3) that does not factor in the $3,825 in sc premiums collected. factoring in those premiums the portfolio loss would only be 1.3%.
>
> Regarding leap time value:
>
> 1) time value is (50+23.36)-69.56 = $3.80 for 615 dte or 2.26% per year.
> 2) time value is 1100 times $3.80 or $4,180
> 3) initial short call premiums collected is $3,825
> 4) therefore, in first month we have almost entirely paid for all the time value, only $355 not covered.
>
> I opened this position as a paper trade in my poweropt. I will keep track of it there and tomorrow I will post profit/loss from poweropt over a range of IWM values at the short call expiration 8/21/2010.
>
> For now, please read, ask questions.
>
> When we need to make adjustments, I would like members to post how they would manage the position. I generally do not make any adjustments until Wednesday before short call expiration if it is ITM. If OTM, I follow closely and if it goes ITM on Thursday or Friday I make adjustments. I avoid assignment at any cost.
>
> I WILL CONTINUE WHEN NEXT 11 CONTRACTS TO BE ADDED AT JUNE EXPIRATION. However, I will entertain questions/suggestions at anytime.
>
> drjoe
>
>
> --- In ConservativeOptionStrategies@yahoogroups.com, "joe & leigh" <gass20@> wrote:
> >
> > DLS-PAPER TRADE #3
> >
> > At risk is the value of the leap = $25,696 out of $200,000 or 12.85% rather than 100% if we bought IWM in the buy-hold portfolio
> >
> > We have $174,304 to put into the dls cash account. The purpose of the dls cash account is two-fold
> >
> > 1) to roll out our leaps at the proper time when new further out leaps are available
> > 2) to purchase additional leap contracts when our minimum monthly income goal can not be met
> >
> > I allocate 30% of that cash for rolling and 70% for purchasing additional leap contracts
> >
> > ie.
> >
> > rolling = 30% * $174,304 = $52,912
> > additional leap contracts = 70% * $174,304 = $122,012
> >
> > Now we need to generate our monthly income by selling short calls.
> >
> > What strike price for the short call?
> >
> > I select the strike with the most time value.
> >
> > What expiration for the short call? (revision of my original DLS Paper)
> >
> > I go out to a 3 month expiration.
> >
> > Let's look at the reasons for my revision. I have had people who initiated a dls strategy purchasing all desired leap contracts and sell near month short calls only to see a market correction. The percentage loss looks enormous and has scared people into closing the position and considering it a failure. A 10% drop in IWM would represent about a 25% drop in the value of our Jan12-50 strike leap.
> >
> > Math: IWM at $69.56 with a 10% drop would be a $6.96 drop in value. Our Jan12-50 strike leap at $23.36 with a delta of 0.84 would drop about $6.96 * 0.84 = $5.84
> > Therefore, our leap would drop from $23.36 to ($23.36-$5.84) $17.52 or a 25% loss of market value.
> >
> > If there is a correction, by going out to a 3 month expiration for our short calls and legging into full leap position over 3 months we purchase additional leaps at a progressively lower premium thereby dollar cost averaging into the position.
> >
> > Another reason is the premiums of the short calls at 3 month expiration are much greater and affords us greater downside protection, often greater than 12%.
> >
> > Another reason is that more often than not the premiums at 3 months will make the difference between our short call and leap strikes greater than our net debit (leap cost - short call income). This is important because even if we sell short call contracts equal to number of leap contracts we are guaranteed a profit. Even if assigned early or at expiration.
> >
> > How many short call contracts to sell?
> >
> > Based on above for the initial positions one could sell at a ratio of 10:10 and have more downside protection, often greater than 15%.
> >
> > However, I will sell at a ratio equal to the delta of the leap. ie....8:10, leap delta is 0.84 so I roll down to 0.80.
> >
> > That allows us to participate in an uptrend of the underlying while still giving us our monthly income goal.
> >
> > So, let's look at our initial short call position.
> >
> > 11 leap contracts * 0.84 is 9.24 rolling down to 9 short call contracts
> > Aug10-70 strike call is $4.25 (100 dte)
> > Income generated is $4.25 * 900 = $3,825
> >
> > Has our income goal been met? Remember this is 100 days to expiration so we need to adjust that $3,825 to see if it meets our monthly goal of $3,333. We can do this by taking the $3,825 * 90 days (3 months)/ 100 days to expiration = $3442.
> >
> > Our monthly goal is met.
> >
> > Before we move on let's look at our net debit (cost basis):
> >
> > Leap cost = ($25,696)
> > Short call premium = $3,825
> > Net debit = ($21,871)
> > Cost basis per leap contract = ($21,871/1100) = ($19.88)
> >
> > Remember, the difference in out strikes is $70 minus $50 or $20
> > That $20 is less than our net debit of $19.88. Therefore, even if assigned and even if we sold ratio of short call to leap of 11:11. We will not lose money.
> >
> >
> >
> >
> >
> >
> > --- In ConservativeOptionStrategies@yahoogroups.com, "joe & leigh" <gass20@> wrote:
> > >
> > > DLS-PAPER TRADE #2
> > >
> > > CONTINUATION
> > >
> > > Our monthly income goal: $40,000 / 12 months is $3,330
> > >
> > > What leap expiration? What strike price for the leap?
> > >
> > > I go out to the furthest one available. If I was actually opening this position i probably would wait until the January 2013 IWM leaps become available in the fall, but the furthest out right now is the January 2012. Reason? the theta of the leap is minimal and the time value per day is smallest.
> > >
> > > I pick a strike DITM and one with at least a delta of 0.80. Reason: there is very little time value at that delta. A major risk of diagonal spreads is changes in implied volatility (vega effect). These changes effect only time value therefore we have minimized the vega effect in our position. (not totally eliminated it).
> > >
> > > Therefore, for our leap position I have chosen the Jan12-50 strike trading at $23.36 with a delta of 0.84.
> > >
> > > How many leap contracts should we purchase?
> > >
> > > In our buy-hold portfolio we had $200,000 to allocate for the purchase of IWM. At $69.56 we would have purchased ($200,000/$69.56) or 2875 shares. The equivalent stock position using leaps would be 2875/delta of 0.84 or 3423 shares or 34 contracts. Since we will be legging into the full dls position over 3 months I will use 3300 shares to make calculations easier. That would be 11 (1100 shares) contracts per month for 3 months.
> > >
> > > We will purchase 11 contracts now and sell short calls with expiration of Aug10.
> > > At June option expiration we will purchase 11 more leap contracts and sell short calls with Sept10 expiration and at July expiration we will purchase the remaining 11 leap contracts and sell short calls with Oct10 expiration. We will, at July expiration, have our desired dls position of 33 contracts.
> > >
> > > Initial leap cost = 1100 * $23.36 = $25,696
> > >
> > > TO BE CONTINUED
> > >
> > >
> > >
> > >
> > > --- In ConservativeOptionStrategies@yahoogroups.com, "joe & leigh" <gass20@> wrote:
> > > >
> > > > Mike Cleveland posted this recently:
> > > >
> > > > "One thing that would really benefit me, and possibly others, would be to "start from scratch." I'm sure you have done this in your paper, but it would be nice to be able to discuss it together to help clarify, for people like me who are new.
> > > >
> > > > It would be good to do a "From the Beginning" post. What is a "DLS?" How do you find good trading candidates? Do you do any ETF "DLS" trading? How far out in the future do you look for candidates? What strike prices? How do you enter? When do you adjust?
> > > >
> > > > If you just did one post per day, starting with the basics, it would allow us to follow along and ask questions.
> > > >
> > > > Would you consider this?"
> > > >
> > > > Most of the answers are in my paper. I am modifying the expiration date for the short calls and will revise the paper when i get a chance.
> > > >
> > > > I can establish an initial dls position and go through the mechanics. However, once established it is pretty boring. Really nothing to do until expiration of the short calls which i am going to change from a one month sc to a 3 month sc which i will explain shortly.
> > > >
> > > > 1) Critical: establish a buy-hold portfolio
> > > >
> > > > For simplicity, let's say you have a $500,000 retirement portfolio and you would like to allocate 40% into equities and 60% into fixed income.
> > > >
> > > > Equities 40% is $200,000. I trade only diversified ETF's and the one's I use most often are SPY, IWM, EFA and EEM. I believe it is very difficult to be successful trading the dls strategy using less than 10 contracts initially. If your capital only allows 10 to 15 contracts trade only one of SPY, IWM or EFA. EEM is too risky, imo, if you can only trade one ETF in the dls strategy. Again for simplicity, let's choose to use all the $200,000 trading IWM in the dls strategy.
> > > >
> > > > 2) Next we have to select a % return goal for your $500,000. Remember, each of us have different goals and we will not all select the same goal. For this example, I will select one. Since returns are higher with more risk and lower with lower risk and since dls portfolio strategy has significantly less money at risk than a buy-hold portfolio I am going to select a 10% annual return on our $500,000 or $50,000 per year.
> > > >
> > > > A diversified bond ETF is yielding about 4%. If we put our $300,000 fixed income portion in that we should return about $12,000 per year. If we set a 20% return on our dls portion, $200,000 * 20% is $40,000. The $12,000 and $40,000 yields $52,000 which is a 10.4% portfolio return.
> > > >
> > > > Summary:
> > > >
> > > > Portfolio:
> > > >
> > > > $300,000 in a bond ETF (like BND) goal 4% or $12,000
> > > > $200,000 in IWM using dls strategy goal 20% or $40,000
> > > > Total return $52,000 or 10.4%
> > > >
> > > > TO BE CONTINUED
> > > >
> > >
> >
>
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