Cycling Earnings Using Spread Positions
In this chapter, we build long-term investment strategies around call spreads on the S&P 500. These strategies benefit from call option characteristics introduced in earlier chapters, including the long-term appreciation of the index, the leverage of call options, the lower marginal cost of longer-term call options, and the differences between implied and historical volatility.
Even when call spread positions are constructed with positive returns, it can still be a challenge to manage the risk and reinvestment of portfolio capital. The standard deviation of investment returns tends to be high, making rapid gains and losses possible and the end result unpredictable. And in diagonal spreads specifically, the use of long and short options with different expiration dates and corresponding cash flows will complicate risk management.
Three strategies are presented in this chapter: a six-month/three-month diagonal call spread held to expiry, the same spread sold after the expiry of the three-month option, and a shorter-term strategy that cycles a portfolio through twenty-four investments a year (making rapid reinvestment possible). We also discuss long-term approaches to modeling volatility and present a relatively simple approach to constructing simulations of weekly or monthly changes in returns and volatility. For more complex strategies, we will need methods like these in order to go beyond historical analysis and model potential ...