Option Strategy Explanation 06 |Seeking bottom hunting but fearing surges,master this strategy!

Tiger_Academy
2023-07-26
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Hello

Welcome to the Option Strategy Explanation 06.

Friends engaged in stock investing often encounter a situation:

They have a strong desire to bottom-hunt a particular stock, but it just won't drop to their desired price. Even after waiting for some time, they find the stock price has instead risen. What should we do in such a situation?

Today, I'll teach you how to use the short double-limit strategy at zero cost to solve this problem!

1、What is the Short Double-Limit Strategy?

The Short Double-Limit Strategy, is a method used when waiting to buy a stock at a desirable price. If the stock price doesn't reach the target price, one can buy an at-the-money call option and simultaneously sell a put option with the target price as the strike price to offset costs.

Here's how it works:

For instance, let's consider Jack, who wants to buy Alibaba stock with a target price of $80 per share. However, the current stock price of Alibaba is $84. If Jack continues to wait for the stock price to drop, it might reverse and rise instead. In this situation, Jack can buy one Alibaba call option at an $84 strike price for a premium cost of $1.31. To offset this premium cost, Jack simultaneously sells 12 Alibaba put options at an $80 strike price, receiving a premium income of $1.32 ($0.11 * 12), resulting in a net premium income of $0.1 ($1.32 - $1.31), nearly zero-cost.

Subsequently, if the stock price rises, the call option can yield a profit, which can offset the loss of not buying the stock at a lower price. If the stock price falls, as long as it remains between $84 and $80, the option combination maintains the same profit ($0.1).

When the stock price drops to $80, Jack can buy the stock at the target price of $80 while closing the entire options combination to avoid unpredictable profits below $80.

By using this strategy, Jack can effectively buy Alibaba stock at $80 with near-zero cost.

However, during implementation, two crucial points should be considered:

1.How to combine the quantities of call and put options. In the above example, why does Jack buy one call option but sell 12 put options?

2.Is this strategy completely foolproof against all stock price movements? If not, how to effectively manage risks?

2、What should we pay attention to in the Short Double-Limit Strategy?

1.Balancing premium inflow and outflow:

In this strategy, when we buy at-the-money call options, the premium paid is relatively high, while the out-of-the-money put options sold at the target strike price generate lower premium income. As a result, the premiums may not fully offset each other. How can we address this?

We can make adjustments to the number of contracts.

Continuing with the previous example, since the purchased Alibaba call option at an $84 strike price costs $1.31, and the put option at an $80 strike price is priced at only $0.11, we can calculate the number of put option contracts to sell: 1.31 / 0.11 ≈ 12 contracts. Rounding up, we can choose to sell 12 put option contracts to achieve a near-zero cost hedge.

2.Risk management

Although this strategy benefits investors regardless of the stock price's movement, if the stock price falls below the target price, the quantity of sold put option contracts will be significantly larger than the number of purchased call option contracts, resulting in losses. Therefore, it is crucial to implement proper risk management in the short double-limit strategy. When the stock price reaches the target price, it is essential to close both the call and put option positions while buying the stock.

Alright, that's it for today's sharing. If you want to learn more about options, feel free to follow our detailed course, "Introduction to Options," where we will continue our discussions.

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