To explain I'll use an example of a diagonal put spread that could result in achieving a position of holding a long put at no net cost. Similar examples occur fairly often with calls.
On Friday, when RIMM was tanking after a disappointing report on Thursday after the close and with RIMM trading around 68-69, there was a period of an hour or two when placing the following spread was possible for no out-of-pocket cost: long the November 2009 60 put, short the October 65 put, for a net credit of a few cents per spread. Best I can recall, you could have bought the Nov 60 for something like 1.45 and sold the Oct 65 for maybe 1.50 or thereabouts (times 100 of course).
Such a position has two negatives associated with it:
1. Should the stock continue to go down in the 3 weeks remaining until expiration of the October contracts, you would be exposed to possible loss of up to $500 worst case. In practice the continued existence of time premium in the long November 60 will usually offset some of that loss, and of course the entire position can be closed at any time with 2 closing transactions.
2. Full margin of $500 will be required to be maintained in the account, since the farther out put is at a lower strike price. On calls, the margin will be required when the farther out call is at a higher strike than the short call.
Should RIMM stabilize near the current level and not fall below 65 at October expiration, then the short put expires and the long put is retained in the account as a "free" option, e.g. it is held at no net cost. If sold at any price prior to expiration, it would be all profit.
The psychological cost and emotional stress of holding such a position can be significant for a volatile stock, especially if the stock price approaches the strike price of the short option.
I watched the prices of the November 90 calls vs. the October 85 calls, but don't recall seeing them trade at prices that could be entered at less than about .20 or .25 cost. |
