Richard,
Obviously, I am neither Herm nor BP, but if I might jump in here, I think there is a bit more to consider in your comparison. I agree with your numbers, but I don't think the appropriate comparison is absolute for the two cases. The relative return, i.e. the ratio of gain to the amount of money you must leave invested to realize that gain for "buy all at once" is 12.5/7.5 or 167%, which is a very nice return indeed. Of course to get that the stock must close above 50 in March. But if you do manage to leg into the spread "for free" as you suggest, the % return can be enormous. As a rough estimate, let's say it takes a month for you to sell the MAR50 at 15 (very lucky of course). Then your daily average investment over the duration of the spread is about $1,000 ($7.500 x 1 month/7.5 months). You can only make $10,000 on your 5 contracts, but the relative return is in the neighborhood of 1000% ($10,000/$1,000).
What is most important is if you do manage to leg in such that your cost and risk become zero, you have your original $7,500 back in your hands, you can forget about that risk free spread (except to be looking for an early exit to lock in profits if the stock runs up) and be looking for the next opportunity to use that same $7,500 for another "free" spread with $10,000 potential, and then another. Assuming your luck holds up, there is no limit to how much money you can make with this approach.
Also, have you considered legging into the spread by first selling the higher strike calls on a stock that is overbought, and buying the lower strike calls on a pullback? The margin requirements are very different in that case, perhaps on the order of the premium plus 20% of the stock price. On a $30 stock that would mean you could sell 10 contracts with only $6,000 in place.
The added risk of legging into a position is substantial, and not to be ignored, but the potential reward is not limited in the way suggested by your analysis. Furthermore, there are scenarios that where legging in can be done with a much higher probability of success. I've been looking at some of these for a while now, and if I had substantial money in a margin account I would be implementing this strategy.
Given the fact that you can use the same money again and again to set up spreads if you are successful at legging in, it seems to me the best approach is to reduce the cost of the spread, and maximize the delta of the calls. That leads to LEAPS. There are many stocks where right now you set up a 2002 LEAPS $10 spread, with both calls already ATM to ITM, where the price difference is about $4, and delta is around 80%. That means all you need is a $5 move in the stock to leg into the spread for free. If you are good at timing your entries using an approach like WINS from Herm, or are generally good at timing a stock's price cycles, you could leg into such a spread in a few days, maybe even in one afternoon, and then do it again and again and again. So my suggestion to anyone interested in maximizing the probability of getting the full potential return, and maximizing the number of spreads you can set up, is to look farther out at near ATM to ITM strikes on good stocks that have, or are in the process of pulling back to prices you think will be long term bottoms. Then if you are willing to risk legging in, the potential gain is unlimited.
Dan |
