Its late and I am beat, so forgive me for this arbitrage question. Its on MTGE. Suppose I want some common but I don't want to pay 25.00. I'd rather pay 24.00. So I will buy MTGE at 25.00(say 1000 shares) and strangle 10 spreads of the Jun15/35 for a 21.00 credit(current bid....could probably do better).
March EX happens and your shares are called away at 15 Short, leaving you down 10.00(25 long purchase, minus 15 short assigned). You carry the short 35 to OPEX and you are Put the shares at 35.00. Subtract your remaining 11.00 credit and you've effectively bought the shares at 24.00. If OPEX is B4 EX in June-- bonus---, collect the dividend. If MTGE trading higher than 25.00, score, dollar per dollar.
Risk, the share price in June is @ 20.00 and you are down 4.00. Alternatively, the share price is at 25.00 and you are up 1.00. You might ask why not just short the Jun25Put for 2.00 and that guarantees 23.00 Put price. But that exposes you to BE @ 23.00, below which, you suffer loss.
My trade above has BE's @ 14.00 and 36.00. Pretty crazy, no?
Why would the Jun 15 be called at March opex?
You paid 25, collected 21, were paid 15, then paid 35 and ended up with 1000 shares.
Your net cost in your scenario is -25+21+15-35 = -24 per share. Check.
What you did isn't a strangle. A strangle involves OTM options, not deep-ITM options. I had to look it up, and it's called a "short guts". The deltas on the two positons cancel between the strikes, then your net falls off above and below the range, making it look like a short strangle. It brings in a lot more cash than a short strangle, but since you're pretty much guaranteed to be ITM until opex on both legs, most of that cash will go to cover being assigned both ways. You get to keep the time value.
It also isn't a hedge for your shares. Your asset value with the shares has a delta of 1 between the option strikes. It's 0 above, costing you profit, and 2 below, doubling your loss. A hedge would decrease delta on the downside, whereas you've leveraged it.
So you went net -4 to enter the position at p=25. You gain at 1:1 up to p=35, where your gains flatline with a max gain net of +6. Or you can lose at 1:1 down to p=15, where you are net -14, and if it continues to fall you lose at 2:1 until the stock goes to p=0, where you are at max loss net of -44.
So by "saving" a dollar per share, you have given up all profits higher than $6 and taken a $44 risk. Your breakeven is at 29.
(Really, your opening cost was $4, so you "saved $21", which seems like a better price to pay for all that end-result skew...)
If you're going to talk about particular sequences of events and trajectories for the price, then your max goes up, but your risk does too. Just staying within the strikes and not trading the shares, you can keep the almost the total of the option premiums (21) if you are assigned the Put near 35 and the call near 15. But you can lose $40-21=19 if the call is assigned near 35 and the Put near 15. So there's a $40 range even without selling the shares, which you can do for a profit or loss as normal.
"Why would the Jun 15 be called at March opex?"
Because the deep ITM Calls track the PPS dollar per dollar(Theta = zero). IOW, the current Jun15Call traded @ 10.10 last, today.The PPS is 25.11, so the option is at Par.
At Mar EX, it will also be at Par. The long holder of the option will exercise(99%) to receive the dividend. If he does his shares are worth 90 cents less, but he has received 90 cents in the dividend to remain neutral.
If he does not exercise and instead keeps the Call, his Call will be worth 90 cents less, on the EX date and he will be down 90 cents compared to having received the dividend. This is why I added the Long share position in this hypothetical example. If you did not buy the shares along with the option spread, that exercise @ Mar EX, would leave you down 90 cents/share and short the shares from 15.00.
YBF, I didn't follow all your explanations, but by my reckoning max gain is +11 (not +6) and max loss is -39 (not -44). (Not infinite risk, as I said earlier, but pretty substantial).
Value @pps=35: stock=+35, call=-20, put=0, TOTAL=15 (net=11)
Value @pps=0: stock=0, call=0, put=-35, TOTAL=-35 (net=-39)
And I was wondering why I was sneezing all day.
I would view (and analyze) this as two different trades:
(a) The long stock at 25.
(b) The short strangle (sell the 15 call and the 35 put).
If you can get a $1 credit for the strangle, that's your $1 profit on position (b) (between PPS 15 and 35, a pretty safe range). (Right now it looks like you can get only .30 though). A lot people sell strangles (and condors, for more safety) on a regular basis for steady income.
Position (a) has a very different profile -- the familiar one of a long stock (with dividend). Chances are it will dominate the outcome of (a)+(b).
So yes, everything that you say is correct -- but can we call it arbitrage? I would call (b) a high probability trade -- in the class of selling deep OTM or (as in this case) deep ITM options. (High probability, but the risk is, in theory, unlimited). And I would call (a) a separate trade (with a significant amount of risk).
BTW the ITM strangle is called "gut" by some people. Who knows why.
Hi Doc, have you thought about doing this trade on WMC? At these levels it offers higher divi and more undervalued then MTGE, no?
P.s. are you still holding UAN, you must be up nicely on that trade, congrats if so...
Hi Igsteri and Insign,
I still hold half of my original lot of JanShort30Puts. I plan on waiting until OPEX and either allowing them to expire worthless(hope), or might roll them to a back month. No hurry, as the more research I do on this company, the more I like the idea of increasing my exposure to additional ShortPuts.