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Hi
Neal,
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Thanks
for your kind comments. The procedure with my broker (OptionsXpress) is
this: On expiration day They notify me if I am likely to be exercised
(i.e. PCS is above 10). If I do not take any action I would end up short
100 shares per contract and long the LEAP contracts, a hedged
position. This has different margin requirements than a calendar spread
and could trigger a margin call. I can then either close the short
position by buying back the stock or by exercising the long LEAP's early.
Exercising the long leaps early will result in a loss of remaining time
premium. Obviously the best strategy, in this situation, is to roll the
calls before expiration.
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I have
heard of options being exercised before expiration and even when they are out of
the money. I believe the reason this occurs is to collect a dividend and
fortunately is very rarely done. In this case the procedure would be the
same except there would be no warning. Te real danger occurs on expiration
day. If PCS is trading close to 10 but still below, say $9.75, there is a
real risk that it could close above 10. The tendency when the call is out
of the money is to let it expire and replace it on Monday. The reason is
that expired options do not generate a commission charge. Rolling
generates 2 commissions, one to sell and one to buy. When using this
approach you must be very vigilant on expiration.
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In
either of the above cases, since there is a choice of how to proceed my broker
will not automatically act. The actual event that would trigger them into
action is an unfulfilled margin call which could occur some time later, or
never depending on the margin available in the account.
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I
agree with your analysis of having 5 possible outcomes and that the most likely
negative outcome is PCS moves below the lower break even point (around
7.00). At this point the strategy would be to allow the short 10 calls
expire worthless and replace them with 7.50 calls. If PCS
STAYS below 7.50 this is fine since you can continually do this,
collecting premium each time. The real problem occurs should PCS rebound
strongly, say to 12.50 or more, particularly early in the life of the
LEAP's. Now I would have locked in a loss. Here the only
reasonable strategy would be to wait till expiration and roll up and as far
out as possible, hopeful for a net credit. (Note that it might be possible
to salvage a trade gone bad by selling 2 call contracts for each leap and buying
1 lower strike call for a net credit).
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<FONT face=Arial color=#0000ff
size=2>As to your second question, it is necessary to screen for the
Long/short price ratio first. As you know not all stocks have options
available, and of those not all have leaps, and many will not produce a
favorable ration (less than 3 to 1). Once a potential candidate is found
due diligence is required. I certainly want a company that has been
around and not likely to disappear (we all remember the internet
bubble). I prefer those in an up trend and with reasonable
fundamentals. Some common sense is also required, for
example, several financial stocks meet these requirements, but since they
do not do well in a rising interest rate environment (more likely in the next 2
years) I eliminated them. By using leaps as a substitute for the stock
this sort of pre-screens the possible candidates to stronger stocks, also it
allows you to chose from stocks that you would not normally be able to afford
(do leaps trade on Berkshire Hathaway?) With that said, it may be
beneficial to use stocks trading around 10 (such as PCS) since the maximum loss
would only occurs if the stock went to 0.00, not very likely, though
smaller than maximum losses still can occur.
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The
best source for option screens is <A
href="">http://www.poweropt.com The cost
is a reasonable $9.95 per month and they have a 2 week free trial. Use
their calendar spread screener and play with the (many) settings till you get
results that suit you.
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<FONT face=Arial color=#0000ff
size=2>Comments cordially invited.
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Good
luck and good trading,
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Ray
Raffurty
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<FONT face=Tahoma
size=2>-----Original Message-----From: sire@xxxxxxx
[mailto:sire@xxxxxxx]Sent: Thursday, February 19, 2004 5:39
PMTo: realtraders@xxxxxxxxxxxxxxxSubject: RE: [RT]
Calendar SpreadsRay,I want to congratulate you
for your presentation of the PCS trade.I think it is one of the best
examples of a well thought-out optionstrategy and one that everyone can see
and appreciate clearly.I also think this trade has a very high likelihood of
success.It is a combination of a bull spread and a calendar trade
withthe advantages of each.In option trading I like to think that
the market has 5 possibleplaces it can go: up a lot, up a little, stay the
same, down a little,and down a lot. This trade has 4 of the 5 possible
market outcomesin its favor. The only way you lose is if the market
goes below 7,and it would have to do that by August.Caveats:1.
Odds are that the short call will be exercised, but you don't knowexactly
when. What happens when it is? Does your broker have
auto-exercise which would take you immediately out of your leap? Is
therea lag time that would expose you to exercise risk? 2. This is a
long term trade. Is your object to own the leaps for freeor to achieve
success with this trade. Sometimes long term goalscan conflict with
short term market action.Have you selected this stock based solely on the
Long/Short ratioor do you have fundamental or technical reasons for your
selection?How do you scan for these
trades?Neal
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