Tuesday, May 11, 2010

An experiment in GE

I want to see how a strategy will play out and it will most likely be a multi-month expirement. What I want to do is look at put diagonals. I am looking to buy a put way out in expiration ATM. So for GE I am looking at the $17.50 put. Then I want to sell front month options against that purchased put. I realize that a few things could play out:

1) The puts I sold expire worthless and I can do it again month after month.

2) The puts expire in the money in which case I take delivery of the stock and start to write covered calls against the stock, which now gets me the same risk profile as a call spread (with a put, stock , an sold call).

3) The puts expire in the money and I could immediately turn around and exercise my right to sell with the purchased put. To me this is the least desirable alternative unless the stock has moved so much against me that it just makes sense to cut the trade with a maximum defined risk.

I am leaning towards trying to play it with scenario 1 and 2 in mind. But am open to the fact that the stock could potentially take a dump making it unappealing to continue forward with the strategy.

So lets take a closer look at what I am going to do:

So I am going to purchase the $17.50 put with Jan 2012 expiration which will give me plenty of time to see how this strategy plays out. This particular put is trading for 3.65. I am going to sell the front month May '10 $17 put which is currently trading for $0.18. This will put my overall cost basis at 3.47 for this diagonal.

I have chosen GE as the experiment stock as it is a name that I know and I think that it is less prone to huge moves which I think would not work well for this strategy. My thesis going into this trade is that this would work for more of a slow mover and not a momentum stock. But only time will tell.

I will post updates to the trade to the comments section of this post going forward.

Leg 1 = Buy 1 $17.50 Jan '12 put @ 3.65
Leg 2 = Sell 1 $17 May '10 put @ 0.18


  1. I also put this on my list to talk about next time I see you. I'm a little confused as to the overall goal. If you're selling the front month going forward hoping that the cumulative decay adds up to more than the long put purchase than there might be a problem. The long put has 21 month left a @3.65 = .1738 per month. The shorter dated puts should be significantly higher than the .18 you got. Under this price structure you break even in 21 months. And if you are right that this stock won't have big moves, that should mean that volatility wanes as time goes on which means theoretically you get less than the .18 a month you just got.

    But maybe your view is that current IV should be similar going forward and thus the premiums should remain similar going forward as well. Like I said I'm not exactly sure what the goal is so I should save any further comments until we talk. Why not just do a 6-month long put and speed up the experiment? If the Mayans are right we might not be around for the 2012 OPEX. I would like to take the lessons of this experiment with me to the next life so I favor the 6-month option.

  2. Lets disccuss when we meet up. But I do expect that I will be able to collect higher premiums going foward. I am selling this one late in the month. But looking foward the 17 and 18 strike in June are trading for .48 and .82 respectivly right now, with GE at 18.12.