Saturday, December 4, 2010

HGSI Synthetic Convertible - Part 2

After my most recent post with the same title I received a very insightful comment with a question related to the trade on HGSI.   The question was "If there is a non-event for HGSI related to the December 9th FDA panel on HGSI's lupus drug or the meeting is postponed, will that not leave the "Perfect Trade" with a loss?"  Would we not simply lose the premium for the call option with no offset? The short answer to this question is Yes.   Let me explain.

The trade itself is set up for an "event" - the upcoming FDA meeting on the 12/9.   If there was no such  large event upcoming for a particular company then the "perfect trade" would be set up differently.   

Given a stock that is just plain volatile, like some other equities ETF's, the trade would be set up with a longer call option.   The premium outlay on the call option could then be offset for the most part by the steady stream of income from the short puts - if the stock price fails to exhibit the same levels of volatility.   If HGSI would continue to show the same volatility in stock prices then we would simply replace the short call (December) with a longer dated one (June/July).    This set up is much better suited for any equity or ETF that might have good consistent volatility versus the "event" scenario.

A very good actionable and long term trade would be to utilize the small cap ETF's (TNA. TZA etc).   Create the trade so that we can reap the benefits of the volatility however ensure that we can offset the premium outlay for the calls if the volatility goals are not met.   So here is an actionable trade to consider using the Small Cap 3X Leverage ETF (TNA).

     Long 10 Apr 11 $60 Calls ($14.20)
     Short 660 Shares TNA ($64.89)
     Short 4 Dec 10 $61 Puts ($1.60)

This trade will allow you to capture the volatility in the stock by trading the hedged short positions but will also allow the opportunity to offset the call premium OVER TIME with the income stream created by the monthly income from the short put positions.   

Great comment from "Animal".

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