Most articles on options go into detail in selecting a particular stock and then offer a simple option play for that stock. In contrast to that style, I try to provide the reader with non-standardized option strategies to add to their arsenal, ready to be deployed by the reader at the appropriate time and with the stock of their choosing.
Before I detail the "Option Triangle," I must stress the importance of THESIS. The first step in any investment plan has to start with the investor's view of the overall market and the particular stock.
The "Option Triangle" is a strategy that can be used when the investor is looking to go long an underlying stock, but wants to be cautious. In short, the investor is confident in the long run, but less confident in the short run. Sort of like "putting your toes in the water".
Now, Apple (NASDAQ:AAPL) can fit this mold. It is dominant in the field and fairly or possibly under-priced. On the other hand, it is subject to the overall market, which may not be as friendly.
A simple strategy that many investors use in situations such as this is the covered call. This consists of a long position and selling a call against the long position. The "triangle option" is a variation that bifurcates the long position. It has three legs as follows:
1. Buy an ATM far-dated call. AAPL is trading at $572 and I choose the April 2013 $570 call for a cost of $70.75.
2. Sell an OTM put. The strike price is chosen by calculating enough premium credit to recover, by selling a put each month through April 2013, the cost of the far-dated call from STEP ONE. There are ten months till the expiry of the April 2013 call, so that means a strike price that will generate about $7 each month.
We don't have quite a full month till the July expiry, so I'll choose the $550 strike that credits $6.40. Close enough. Of course, on each successive month the strike price may vary depending upon the movement of AAPL, but is likely to be at least $25 below AAPL's then current trading price.
These first two legs make up what I call a "calendar synthetic" long. It is important to understand how they work together, so you can judge the relevance of the strategy.
When one buys an ATM call, the ATM call will, initially, move up one-half the move of the underlying. The more the underlying moves up, the more the call moves ITM and will steadily increase the percentage it moves; to, say, 60%, 70%, 80%, etc. If the underlying falls, the call moves OTM and the reverse holds true with say a 40% loss of the down-move. Now, as far as the OTM put that is sold, for simplicity, I'll assume the reader knows how the OTM put works.
Combining these two features gives us the following result as of the July put expiry:
1. AAPL goes nowhere. The put is a $6.40 gain, the call loses a little time decay. Not too much, for an overall net gain between $5-$6.
2. AAPL falls, modestly. If AAPL falls less than $14 (stays above $550)the call will lose one-half while the put gains $6.40. Overall, some gain. Contrast this with a pure long position which would have lost the entire down-move.
3. AAPL falls BIG. The call loses somewhat less than one-half the drop. If AAPL moves below the OTM put strike of $550, the put starts to "give-back" some of the $6.40 and if the drop is below $543.60, the put also has losses.
So, let's say AAPL falls to $515. That's a $57 drop and the April call will lose, say, $27. The put has also lost $28.60 ($550 strike minus $515 plus $6.40 credit). Total combined loss is $55.60. This is the approximate "break even" point compared to an outright long stock position. Thereafter, this "calendar synthetic long" will lose 150% of the down move.
4. AAPL moves up. The April call will gain one-half the move and the OTM put is a $ 6.40 gain. The reader can do the math, but the upside "break-even" is approximately $590. Thereafter, the "synthetic calendar long" gains only slightly more than 65% of any continued up-move.
Looking at all possible outcomes of these first two legs (the "calendar synthetic long") some upside is traded for downside protection. This fits the thesis.
I promised you a "Triangle Strategy," and that means a third leg. Well, this part, at least, is pretty simple. It is the covered call for the "synthetic long". This is always a problem with a hi-beta stock like AAPL. On the one hand you want protection against a down move yet not lose on a big run-up.
Keeping in mind that there is reasonable down-side protection afforded by virtue of the first two legs, this call should be sold somewhat further OTM than you would normally consider. So, if you would have sold a call at $600, I'd look to $620.
So, there you have it, a "Triangle Strategy". A straddle making up two sides and the far-dated call making up the third.
Conclusion: When the investor is optimistic about a stock, but wants to proceed with some caution (more so for market concerns rather than that particular stock) a "triangle strategy" may be a good alternative.
"Tweak" = If you think a big uptick is likely (say around earnings release) you may want to consider delaying the third leg (selling the call) or selling the put closer to-the-money, or, for that matter, both. If you were pessimistic, sell either the call closer to-the-money or the put further OTM.
This could be done any time a monthly expiry comes into play.
Disclosure: I am long AAPL. I buy and sell puts and calls on AAAAPL