Thursday, August 12, 2010

Viewer Mail - Long Call/Short Put Combo

Hey Tyler,

I'm long term bullish on TM and think most of their issues are over and they make a great product. What are your thoughts on selling some short term puts (Aug or Sept. 70) to help buy a LEAPS call like the Jan 2011 or 2012 75 or 80 strikes? I then could continue to sell puts each month against the call to generate cash flow?

Thanks, V-

Keep in mind buying a long term call option and selling puts are both bullish strategies. It's not as if the short puts are hedging your exposure on the call or anything. So, I would simply look at your idea as two different bullish strategies. By buying a long term call you're acquiring positive delta. By selling short term puts you're simply acquiring more positive delta. So it's inaccurate to say you're selling the puts "against" the long call. As to whether it's a good idea, it really comes down to how bullish you are.

If TM behaves as expected, then selling puts and buying the call will produce more profits. However, if TM drops in value you'll get hit on both the short puts and the call. Furthermore, the short puts open you up to unlimited risk. It's certainly a legit way to place a bullish bet, but just know there isn't necessarily any distinct advantage to combining a LEAPS call with short puts.

The more popular approach is to sell short term calls against the LEAPS, thereby acquiring negative delta and thus a partial hedge against your long call. This would simply be a calendar spread and works best in neutral to mildly bullish environments. Keep in mind long term calls are very sensitive to changes in volatility making it ideal to purchase them when vol is cheap. For what it's worth, TM implied vol does seem to be on the lower end of it's historical range. Here's a quick risk graph comparison of the two strategies (click image to enlarge).

[Source: MachTrader]

I'll point out two key differences and leave it to you to draw other conclusions. First, the position delta on the long call/short put combo is much higher (96 vs. 30), making it a more aggressive, directional bet. Second, while the calendar spread risk is $600, the long call /short put combo is unlimited.

For related posts, readers can check out:
The Oracle Calendar
The Oracle Calendar Part Deux
Naked Puts vs. Put Spreads

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