From the introduction, here’s the current status of the example stock replacement strategy: Long 10 x GOOG Mar 610 Call @ 95.4 = $95,400
The second phase of this strategy involves shorting common stock against the long calls. The calls act as protection against your shorted common. This effectively creates a put against your calls. So how would this work in the money making cycle? I sat around for a bit thinking about how it worked. Using Google again, let’s go ahead and short 50 shares at the current price of $673. Now our example strategy shows the following
Long 10 GOOG Mar 610 Call @ 95.4
Short 50 GOOG Common @ $673 = $33,650
Here’s where the cycle begins. As the price of Google increases, the call value should increase on an almost 1:1 scale while the shorted common begins to depreciate in value. Here’s what our model portfolio would look like assuming Google increases $20 in value:
Long 10 GOOG Mar 10 @ ~115.4 (from 95.4)
Short 50 GOOG @ $693 (from $673)
The total profits from the increase in value are approximately $20,000 from the increase in call valuation minus $1,000 from the short common depreciation, giving you a net profit of $19,000.
Not a bad trade… not bad at all.
As the price of Google drops, the shorted common increases in value while the long calls decrease in value. This strategy limits your downside risk depending on the amount of shorted common you have against your long calls. Assuming Google drops $20, here’s what our example shows:
Long 10 GOOG Mar 610 @ ~75.4 (from 95.4)
Short 50 GOOG @ $653 (from $673)
Total losses in this case would be $20,000 from the long calls - $1,000 from the appreciation from the shorted common, giving you a net loss of $19,000.
Awful… just awful.
This is where phase three of the strategy comes in. According to Cramer, with a high momentum stock, it’s possible to increase income through long calls, shorting common, and shorting calls near the stock price in the current expiration month.
A-ha! Shorting calls! That’s the bond that ties the strategy together.
Taking Google once again, let’s look at what the $670 and $680 strike prices are going for in November 2007.
The GOOG Nov 670 Calls are going for approximately $24 while the Nov 680 Calls are going for approximately $19. The key to shorting these calls is that, on a high flying stock, as I understand options the deeper an option goes into the money, the less “punch” the option has since it’s delta begins to approach 1. It’s that initial punch that we want to capitalize on. Let’s take the $680 calls for this example. The key is to short half of your long calls. For the sake of simplicity, let’s short 5 Nov $680 calls all at once. In reality, I would assume you’d short the calls on a staggered basis depending on an increase in implied volatility as a result of some event but for now let’s load up the lot all at once.
Long 10 GOOG Mar 610 Call @ 95.4
Short 50 GOOG Common @ $673
Short 5 GOOG Nov 680 Call @ $19 = $9,500
This strategy effectively creates a debit spread with a simulated put protected by the long calls. See what I meant by not very simple? I can understand why some traders wouldn’t deal with this type of strategy. It requires much more thought and supervision than other strategies.
After closing out the above strategy, you’re left with a net debit of $52,250 for control of 450 shares of Google. Remember that controlling 450 shares of Google outright would cost about $300,000 at $673.
So how the heck does all of that above continuously bring in money and why even bother? I’m not entirely sure myself. Guess we’ll see what happens in the last installment!
