Below is a snapshot of the VLO current position on July 31st 2012 at 4pm. Current price is $27.51.
2 trades were executed on 6th July 2012 :
Close position : Long 7 VLO Dec 2012 Puts strike $22 : bought $3.15, sold at $1.52 = -$1,153.22 (loss)
Open position : Long 7 VLO Dec 2012 Puts strike $27 : bought $4.11 (cost $2877)
REALISED GAIN/LOSS *
Closed position : Long 6 VLO Sept 2012 Puts strike $26 : bought $3.70, sold $2.44 = -$756 (loss)
Closed position : Long 6 VLO Sept 2012 Puts strike $29 : bought $3.95, sold at $7.65 = $2220 (profit)
Closed position : Long 7 VLO Dec 2012 Puts strike $22 : bought $3.15, sold at $1.52 = -$1,153 (loss)
Total: $311 (profit)
(* including commissions)
Open position : Long VLO 650 shares : price is 27.51 = $1788 (gain on 600 shares) + $297(gain on 50 shares) = -$74 (loss)
Open position : Long 7 VLO Dec 2012 Puts strike $27 : bought $4.11, price is $2.32 = -$1253 (loss)
Total : $832 (loss)
(* including commissions and assuming worst case option prices)
Total strategy return is : $1143
Strategy is up 6.7% ($1143) although for comparision underlying stock (“buy and hold”) is up 12.1% ($1788)
Strategy is now UNDERPERFORMING buy and hold, particularly due to recent rally into Q2 earnings and subsequent pop up today.
This type of rally is the worst condition for this trading strategy, especially where you initially hedge with put options that have a delta of 50% to 60%. However we have acquired an extra 50 shares, and with our next hedge it is possible that we will have hedged away all risk with the trade for this year. i.e. whatever price VLO has between now and Dec 2012 expiration, we will have a guaranteed profit…
The Dec 2012 strike $27 that we now own, has become OTM (from ITM when it was purchased) and is now 100% time value.
As such it will be decaying every day (altough expiration is in more than 4 months, so we dont have to rush to roll up).
If we actually do roll up by buying Dec 2012 strike $30 (at $4.2) after selling Dec 2012 strike $27 ($2.32), this will cost us $1.88, locking in $3 ($30-$27 strikes). This will mean that we can guarantee to sell our 650 shares at $30 – $4.22 = $25.8. This will give us a guaranteed profit of (25.8 – 24.53 on 600 shares = $762) and (25.8 – 21.58 on 50 shares = $211) which is a total of $973.
We have lost the following on hedges : $311 (realised hedge gain) – $1253 (unrealised hedge gain) = -$942
Therefore if we make the rollup trade, we will have a guaranteed minimum profit of $31 ($973 – $942) by Dec 2012.
The point here is not to get excited about making $31 (!) – it is this is now guaranteed whatever happens.
We have just removed any downside risk for the rest of the year.
This also assumes that we hold the position to Dec 2012 expiration (and ALL of the time value drains out of the option), which we wouldnt let happen. So in reality the locked in profit is higher than $31.
The upside is up to VLO price movements, and obviously we could rehedge again if we get to higher prices somewhere between now and Dec 2012.
It is also worth noting that this locks in 2 dividend payments as well (approximately $113 x 2 payments = $227.50) with no risk.
We may make this rollup trade, or alternatively we could start selling near month volatility to make up for the lost put premium on our existing put (Dec 2012 strike 27). We could now sell calls or 2:1 ratio spreads, or maybe sell 1 or 2 put contracts to try and get some more shares at lower prices. If we do this consistently month to month into Dec we will “win back” some premium that we are sacrificing in the put option (to reduce the hedging losses).