The strategy you outlined in post #1 is not uncommon using options with little time value left, which reduces susceptibility to whipsaws. The strategy can greatly backfire if the stock is rollercoaster-volatile, as your shares may get called upon an exercise before the expiration date, leaving you short the remaining option 'naked', these equity options not being European-style of course.
The closer you get to expiration, the less risky the strategy, but of course, the premium income is far less.
Ex. the Thursday (one day) before the upcoming 8/20/99 expiration, a popular strategy that will be used by all the big I-bank/market makers is as follows. This scenario occurs probably 2 out of every 3 options expirations, primarily in quarter-ending expiration months.
Mid-day Thursday, DELL is at 42.5 With one day left, the August 42.5 calls and puts are both bid 5/16 ask 3/8. An IB/MM such as GSCO, with an inventory of say, 100,000 DELL shares, may choose to write several thousand calls and puts on both strikes. Other IB/MMs may follow suit. Then, lo & behold, the stock closes Thursday at 42.5 and never waivers more than 1/8 on Friday, where it closes at 42.5. GSCO keeps the premium. They may do this with several stocks, but they'll stick to NASDAQ 100 issues, where the brokers seem to coordinate frequent, rigged collusion on expiration Friday's in order to record some trading income. Talk to any trader at an options firm such as Spear, Leeds, Kellogg or Hull Group and they will give you a wink when you mention this 'phenomon'.
A more interesting strategy, completely riskless, can be used when merger buzz causes the volatilities on a stocks call options to exceed those on the put options.
Ex.
Last fall, MEL was rumored as a takeover target by CMB. MEL rises $7, from 68 to 75 in just 2 days on the buzz, sending the option volatilities soaring. That day, with 2 weeks left, the Sep 75 calls are bid 3.5 ask 4, the 75 puts bid 2.75 ask 3.25, and the 70 puts are bid 1/4 ask 3/8.
You buy 100 shs of MEL for a total of $7500 & write 1 Sep 75 call for $350, making your net cost so far $7150. You then buy 2 Sep 70 puts for a total of $75, making your net cost for the entire transaction at $7225. SO what can happen here? If MEL gets a bid from CMB, say for 75, your shares may or may not be called, but either way you'll have a net gain of $275 from the premium income. If MEL gets a bid from CMB for 80, you still make the $275 only because your shares will be definetly called for exercise. If shortly after this trade is put on, CMB says that they have absolutely no interest in acquiring MEL, and MEL tanks to 71, you dump the shares for a $400 loss, but this is offset by the $350 in premium income you made by writing the call, plus now you sell back the put at a profit since the vols obviously went up now that MEL has slid. If the bid on the 70 puts is $1, you will have a net gain of $150 after all is said and done. And if MEL even tanks to 65, you can sell the shares at a loss of $1000, which is a net loss of $650 after taking into account the premium income from the written call, and then you can sell back the 2 puts for a very handsome profit of over $1K, making this the most profitable scenario of all the above.
I would ot buy the Sep 75 puts because they are too expensive and the whole basis of the protection outlined above is that I'm buying 2 Sep 70 puts instead of just one, because they are mispriced.
The bottomline of the strategy is to take advantage of the arbitrage that is available when there is a rampant imbalance of demand for call options when a company becomes 'in play', but you often have to act within the first half hour of the frenzy in order to maximize the profit potential.
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