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Tuesday, April 26, 2011

Playing the mutually exclusive advantage : $SPX $IWM

Option Delta: An underlying stock has a delta of 100 & at the money call & put's delta add up to 100. Holding an at the money covered call the reduces the delta of the position by about 50% and hence is able to hedge partially  in to a risk reduced position

But if you are confident of the markets direction, you can enhance your profits by adding a put sell to the above trade. The beauty is in the fact that it's mutually exclusive but still is able to bring the delta back to 100 since it cancels out the delta of the sold covered call.

As long as the position is active it cancels the hedge for the sold call but at expiry plays to your advantage since only one of the two contracts gets assigned. This can be played to the advantage of doubling your total profits even when reducing your position size by half. This can then be classified as risk management at its best and works very well when the option strikes are $1 apart. This strategy can be used to capture monthly return on investment of about 20-25% on a give position essentially doubling your investment capital in a period of 4-6 months.

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