What is wrong with the following stock/options trade? It shows enormous returns. Please help!?

Question

To all stock/options investment gurus,

Security: Ebay
Current Price: 33.69
Assumption - Till Jan08 price will be between 0.7 * 33.69 and 2 * 33.69

Leg1 - Collar(call sp,call prem,put sp,put prem)=(1750, 1700, 1750, 20)
Leg2 - VerticalcallSpread(bcall sp,bcall prem,scallsp ,scallp prem)=(5500, 25, 4000, 215)
Leg 3 - VerticalputSpread(bputsp,bputprem,sput sp,sput prem)=(4000, 730, 5500, 2120)
Table of returns is as follows:

Initial Investment: 108

ProjectedPrice,MoneyIn,Gains,GainsPerc
20 250 142 (131.4814814814815)
22 250 142 (131.4814814814815)
24 250 142 (131.4814814814815)
27 250 142 (131.4814814814815)
29 250 142 (131.4814814814815)
31 250 142 (131.4814814814815)
34 250 142 (131.4814814814815)
Same till price = 69.

What is wrong? Commissions are not considered.

Well...

Collar = buy security, sell call, buy put
VerticalcallSpread = buy call, sell call
VerticalputSpread = buy put, sell put

Legs of trade are:

Leg1 - Collar(call sp,call prem,put sp,put prem)=(1750, 1700, 1750, 20)
Leg2 - VerticalcallSpread(bcall sp,bcall prem,scallsp ,scallp prem)=(5500, 25, 4000, 215)
Leg 3 - VerticalputSpread(bputsp,bputprem,sput sp,sput prem)=(4000, 730, 5500, 2120)

sp = strike price for the option
prem = premium for the option

so, bputsp = Buy Put's Strike Price
sputsp = Sell Put's Strike Price

Is there any other specific info. that you need ?

Leg1 - Collar(call sp,call prem,put sp,put prem)=(1750, 1700, 1750, 20)

This means:

Buy 100 shares
Sell 1 Call of strike price 17.5 with the premium of 17.0 (Total Price = 1700 = 17 * 100)
Buy 1 Put of strike price 17.5 with premium of 0.20 (Total Price = $20 = 0.20 * 100)

Zman, Thanks.

Well.. I agree that Leg1 is separate than Leg2 + Leg3, but then I am using the capital generated by Leg2 + Leg3 to finance Leg1. Hence I clubbed them together. But one can leave Leg1 out.

Also, I agree with you about the American style of options. Here is a shot at the analysis.

There are 3 interesting regions of price line.
R1 : price <= 40
R2 : 40 < price < 55
R3: 55 <= price

In R1 and R3, I am protected by my spread positions (i.e. my liability is 1500)

R2 is tricky as it leaves the sold call and sold put in the money. Lets say I get a assigned on both of these options and lets say that the price is $50.

Exercise on put @55:
So I buy at 55 and sell at 50 (market): Net -5

Exercise on call @40:
So I buy at 50 (market) and sell at 40: Net -10

So, at no point my liability is more than -15

Now the tricky part is to analyze the case where only sold put gets assigned and not the sold call.
In that case, I close the sold call position. (Cont'd)

cont'd from the previous one:

Now the sold call (being in money) will hopefully trade linearly with the price of the underlying security (and price of the sold put, which is also in money).

What say you? I would really appreciate your opinion.

Thanks a lot again!

Hi Zman,

Your analysis is quite right. You had said:

Long 1 $55 call @ $0.25 = $25
Long 1 $40 put @ $7.00 = $700
Long 100 shares @ ($55 - $21) = $3,400

Total cost = $4,125.

If you end up exercising your long put, your return will be $4,000, for a loss of $125.

Well, the loss is because the intrinsic value of my long put option is being eaten away by my exercise of the put option. I would do the best of

1. Sell the put + Sell the stock OR
2. Exercise the put

In your analysis, if the assumption is that everything else stays the same, then I think #1 will produce better cost than #2.

My goal is to profit from the decaying time value of the options without incurring any risk.

Thanks for your analysis. It has been extremely helpful!

Answer 1

Thanks for clarifying.

You really have two spreads. What you cave called "leg 1" in really a conversion.

Since quotes change while the market is open, I'll do the math using Friday's closing quotes, the bid for sales and the ask for buys.

Buy 100 shares @ $33.99 = $3,399
Sell 1 $17.50 call @ $17.30 = $1,730
Buy 1 $17.50 put @ $0.20 = $20

Total cost = $1,689.

Value of spread at expiration = $1,750

Total profit = $61 = 3.6% of cost.

You would make more buying a CD.

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What you are calling legs 2 and 3 is actually a box spread.

Buy 1 $55 call @ $0.25 = $25
Sell 1 $40 call @2.30 = $230
Buy 1 $40 put @ $7.00 = $700
Sell 1 $55 put @ $21.00 = $2,100

Total Credit = $1,605

This looks good since at expiration it would only cost you $1,500 to close the spread. As the old saying goes, if it looks to good to be true ...

The problem is that options on stocks are American style, meaning that the can be exercised any time before expiration. In this case, it is fairly safe to assume that you would be assigned the $55 put shortly after you sold it.

Any time you sell a put for less than its intrinsic value, you are giving a the buyer a risk-free profit.

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Conversions and box spreads are are arbitrage positions. You will never find one that earns more than the "risk free" interest rate.

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If the short put is not assigned early you have a winning position since you will have been paid $1,605 for something you that will will close for $1,500 at expiration. (You noted it would never be more than $1,500 which is true, but it is also true it will never be less than $1,500.) Your profit will be $105 plus 10 months interest on $1,605.

However, since you can be fairly sure of being assigned early, the picture changes as follows:

Credit from opening the spread: $1,605
Cost of buying the stock at $55: $5,500
Cost to cover the short call: Unknown

If we make the highly dubious assumption that your cost to close the call is the same as what you paid for it ($230) you will be left with

Long 1 $55 call @ $0.25 = $25
Long 1 $40 put @ $7.00 = $700
Long 100 shares @ ($55 - $21) = $3,400

Total cost = $4,125.

If you end up exercising your long put, your return will be $4,000, for a loss of $125.

It is also worth noting that the combination of a long $40 put and a long stock position is equivalent to a long $40 call. As of Friday's close that call's ask quote was $2.35. So, an equivalent position wourld be

Long 1 $55 call @ $0.25 = $25
Long 1 $40 call @ $2.35 = $235

Total cost = $260

While it is true if these options expired worthless you would lose $260 instead of $175, the fact that you would earn more than $85 interest on the extra $3,865 in your account makes that a better choice. The fact that you would have fewer commissions further enhances the benefit.

Answer 2

Your trade seems to be ok since you are financing you have a self financing strategy and a strange stock to play with which moves up from less than 20 to assumed 60 and above in short time. Superficially it looks OK.

Answer 3

I would but it's too tough to figure out all the way you've noted all these trades. Put it in plain language and I'll take a look.

Answer 4

Many companys post inflated projected gains.

When they fail to meet them, the price plunges.

Like any other stock, price can go up or down.