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# American Capital Agency Corp. Message Board

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• reits_r_us reits_r_us Feb 10, 2013 6:08 PM Flag

Hi Jess and Aapl1000,

I hope you are in full recovery mode Jess after the hospital stay. I wish you good health...

I think you both misunderstand the beauty of this trade if purchased at the right price. I pay through the nose for commissions from Fidelity on high option orders. The round trip for this Butterfly will cost me a few bucks North of \$500 for commissions, on the 800 contract round trip(400 options on both sides).

You place the order as a "Butterfly" spread and bid a certain price. Right now the spread is -.42/+.42 with a midpoint of EVEN or zero cost. Are you kidding!! No MM will take it at EVEN(maybe), but maybe they will for .10, which would cost you \$1,000 for the 100 contracts(BTW does everyone know that when you buy a Butterfly, or any spread, the cost you pay or the credit you receive is the bid/ask you enter times the number of contracts on the wing, or lowest member, not the body. That is, the ratio is 1:2:1, with the wings the 1's and the body the 2, hence "Butterfly").

So on the 100:200:100 Butterfly @ .10 cost, you pay 10.00 x 100 contracts or \$1,000. Then you have the commissions( I pay)of \$500.00, so a net cost of \$1500 if I get filled @ .10. So that changes your BE on the 33/34/35Put Butterfly to 33.15 to 34.85, with the sweet spot being @ 34.00 at which point, if OPEX is @ 34.00 a profit on the 35 wing of .85 x 100 x 100 = \$8500.

You let this expire to answer both your questions(so the spread is moot). I bet heavily on the OPEX coming before the EX date. So whatever price we are at on March 15th close will determine my profit. All I can lose is the \$1500 cost(Do you get that part??). The beauty of the Butterfly is that you are protected beyond the 1500 cost down to zero PPS, IOW totally. If you get the trade at EVEN, SCORE!! You have a zero risk bet outside commissions...that is what is so incredible.

Get assigned..SCORE, if your brokerage will allow you to float the shares if you don't have the cash to buy them. As I said, then you want the EX to come before OPEX and you reap an extra 20,000 shares x the dividend...how great is that? Then post EX when OPEX comes everything dissolves in the mist because your Long 33s and 35s have you totally protected.

Suppose the PPS goes to 30 post EX @ OPEX. You were assigned @ 34 so you are down 4.00 on the 20,000 shares or \$80,000. The 100, 35s are worth 5 x 100 x100 or \$50,000(and assigned Short as 10,000 shares@35)and the 33s are worth 3 x 100 x 100 or \$30,000(and assigned short as 10,000 shares @ 33), so you BE.

If the dividend is 1.25 you walk away from the trade with \$25,000 (1.25 x 20,000) minus the commission. Pretty awesome..can I lose the \$1500? You bet(outside 33-35 @ OPEX). Do I think it is worth the risk? My GTC order is waiting for the MM. I'll keep you posted...;-)

DocReits

Disclaimer: You can be assigned on this trade and become responsible for buying the 20,000 shares @ 34 in this example @ a cost of \$680,000. That was on a 100:200:100 Butterfly. If entering this trade please do so with enough resources to cover this potential cost. You can modify the number of contracts to meet this requirement, as an example 10:20:10 Butterfly, wherein your potential cost becomes \$68,000, with a potential max reward of just over(commission difference) \$850.

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• lornekenney@ymail.com lornekenney Feb 11, 2013 12:33 PM Flag

AVE Doc:

Learning Latin was easy compared to understanding options.

Doc, I just looked at the January 2014 Call Options with \$30 strike price and compared it with the share price. The bid/ask \$2.40-\$2.62. AGNC is trading at \$32.40. Normally a call option trades at a price above the strike price and that price is higher the longer the time to its expiration. I think they call that the "time premium". In this case it appears to be very low, close to zero.

Why is that? Can you explain?
Unless I am missing something, one could buy the call options and get the same swing in gain (or loss) as buying the shares, but without laying out nearly as much money. I know that one would not get the dividend but it still looks like a good way to bet on AGNC.

• Hey Lornekenney,

Yes, you are correct. Probably the most money I and others have made over the past three years with AGNC is in purchasing and selling or exercising deep ITM Call Leaps. You normally can get Leaps for a better price than the front months and you hit upon the reason already.

""Normally a call option trades at a price above the strike price and that price is higher the longer the time to its expiration""

Except for high yielding securities, like mReits, BDCs, MLPs, etc. Look at PSEC. Its 10.00 strike is cheapest for Aug(furthest back month), compared to the closer front months. You can get it at Par with today's price.

"Unless I am missing something, one could buy the call options and get the same swing in gain (or loss) as buying the shares, but without laying out nearly as much money"

Which I have written at length about. This is the advantage of the option trader over the Long share holder. The advantage is present during different events which need a high probability of movement of PPS in the correct direction...like dividend runs. So on a highly predictive stock you can leverage winnings by purchasing options(Calls), IF the price moves in your direction, with a much lower cost than buying the equivalent number of shares. You are correct.

""I know that one would not get the dividend but it still looks like a good way to bet on AGNC.""

You notice my highlighted "IF" above, and therein is the answer to why the Leaps are cheaper..the dividends.

The Call option buyer, suffers the unique experience of being in limbo if the PPS does not move in his direction. While true he has more time to get the movement correct, it is that very time during which the Long share holder receives their dividend or "Dividends". If the PPS never moves higher than where the option trader entered his trade(at Par) then he receives his price he paid for the option at expiration, in say Jan 2015.

The Long share holder, OTOH, has received 8 dividends, EIGHT!! 1.25 x 8 = 10.00. So the reason the Leaps are less expensive is because of this increased risk of the PPS(this is important) to be reduced by its continuing depletion of the increasing number of dividends to that further out date.

IOW, every time a dividend is given the PPS is reduced by the amount of the dividend. Yes, AGNC recovers, but that is a risk...that it might not, and the more and more dividends out to the LEAP OPEX adds more and more risk that it won't recover all of the 8 dividends. So you, buying at Par on a deep ITM Call, take on that liability.

Therein also lies the advantage for the Long share holder. Yes, he puts out more cash to hold the shares, but the PPS doesn't have to move an iota for him to collect all of those fat dividends.

This is also why I Short Puts. Those deep ITM Puts have all of those eight dividends normally in the price of the Put(right now the MMs have them priced @ 1.00 going forward). So someone shorted 100 14Jan45Puts today for 16.95 or a BE of 28.05, sweet!

So you count down from the 45 strike to today's PPS to see how the MM thinks. 45 - 32.38 = 12.62. So how did they get that 16.95 pricing amount to place in the credit for that Put? There are four dividends coming before expiration, so that is 4.00. There is the difference between the PPS today and the strike = 12.62.

Add and you get 16.62, which leaves .33 Theta or time premium. If the MMs were thinking 1.25 dividends going forward the trader could have gotten more for his credit. THAT is why I am waiting for the announcement before I short any more Puts. I might be shooting myself in the foot if the PPS hits 34.00 before the announcement.

For that 45Put...If the PPS reaches 35.00 again by this coming January he walks with 16.95 minus 10.00 or 6.95/contract. Here is the beauty of the Short Put....he collects those dividends the same as the share holder if the PPS remains exactly the same as today until expiration. That is why you want to short Puts when the PPS is at a low. It gives you the best opportunity to collect the dividends(in the Put premium), as the PPS recovers or at least does not fall below the PPS upon your initial credit.

That Short Put trader also risks being on the hook for 10,000 shares assigned @ 28.05 net PPS. There is always a risk...but that's the market.

Hopefully this answered your and others' questions regarding the pricing of Leap options.

Regards,

DocReits

• Thanks for the reply. I think you are correct that no MM is going to be interested at \$0. I really have no feel for how much they would want so I hope you are able to get a decent execution. I've had disappointing results on getting fills on complex orders (through Fidelity) when I shave too much off the spread but I don't like to play the full spread either.

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