Strategy

scaffold spread

Type of Strategy

investing

sentiment

bullish

implied volatility

high

description

For Long Term Investment in highly volatile stocks with a priority to risk reduction:

Rather than purchasing stock outright or as a stock substitution, a scaffold strategy provides a vertical spread that both raises the floor and lowers the ceiling of the return profile.

This strategy only fits specific situations for certain underlyings, generally with smaller companies that have significant volatility and higher risk exposure.

set-up

Purchase a DITM 65-90 delta (delta based on option IV profile) long-term or LEAP call option for long-term investment with extrinsic value E1.

Sell an OTM 20-60 delta long-term or LEAP call option with the same expiry as the long call option with extrinsic value E2 such that {E2>E1}.

Invest the cash saved in a very low-risk vehicle to boost financial returns.

Scaffold Spread: TMDX

example 1 – tmdx

Investor has 100 shares of Transmedics Group Inc. (TMDX) and wishes to reduce risk in the position at the cost of a reduced maximum return.  TMDX currently priced at $42.85/share.

1) Sell 100 shares of TMDX at $42.85/sh for $4,285 cash proceeds.  (Note tax impact)

2) In an offensive account (tax-free), purchase a 205 DTE (the longest available), 75 delta call option with strike price of $35 for $17.00.  (E1 = $9.15)

3) In the offensive account (tax-free), sell a 205 DTE, 50 delta call option with strike price of $60 for $9.15 (E2 = $9.15).

4) Net cash usage for the position is $17.00-$9.15 = $7.85/sh, or ~$785.

5) Considerations:  E2>=E1  ($7.85+$35 = $42.85 <= current price)

6) IMPORTANT: Notional Consideration: Even though cash investment is only $785, this equity should be managed at full notional exposure of $4,285.

7) Cash savings from scaffold spread = $4,285 – $785 = $3,500.

8) Account holder invests $3,500 in a defensive account (Index Mat example).

  A. Sell an SPX 180 DTE put vertical at the 3-delta level which is 40% below current SPX market value.  This spread has an annual yield of ~4.5%.

  B. SPX index options receive preferential tax treatment as Section 1256 contracts.

  C. Account holder must roll SPX put verticals at ~180 days for continued returns

  D. After-tax financial return on SPX spreads is approximately $119

7) $119 return on 100 shares TMDX = $1.19 per share

8) $1.19 / $42.85 = +2.8%

9) Benefit of stock substitution strategy is approximately 2.8%

advantages / disadvantages – tmdx

+ Reduction in cash outlay for position in underlying

+ Risk reduced from $42.85 per share to $7.85 per share maximum loss

+ If losses occur, long strike closes in on ATM price, increasing extrinsic value & mitigating losses

– Maximum realized price appreciation capped at short strike = $60 

– Maximum spread value of ($60-$35) = $25/share, for a gain of $6,000-$4,285 = $1,715 notional

management – tmdx

SOI recommends a written plan for scaffolding spreads.

  – If losses occur, at what point will the investor sell the positions (potentially mitigating losses due to increased IV with falling stock price and long option nearing the ATM strike)?

  – If losses occur, will the investor roll down the long option and/or the short option to mitigate losses by selling higher extrinsic value options while buying lower extrinsic value options?

  – Investor sentiment regarding the stock is key to these decisions.  Do the favorable conditions that sparked the investment decision still exist?

  – If the stock appreciates, at what point, if any, will the investor add to the position, either through additional contracts (managed at notional value), by rollout out / out and up in time, or by simply rolling up the short option?

Scaffolding spreads provide a means for option investors to take positions in companies where the risk profile would normally dissuade investment.  SOI recommends that any investment decision, regardless of option strategy used, be made in the context of owning shares outright at full notional value.  Scaffolds may provide an improved risk profile as a significant benefit, but investment decisions should be made based on company appraisal rather than investment profile.

example 2 – gm

Occasionally, some less volatile stocks may lend themselves to a scaffold spread.

Investor has 100 shares of General Motors (GM) and wishes to use stock options for a better risk return profile based on personal expectations.  GM is currently priced at $55.90 per share.  The investor believes that GM is undervalued at this price, with a maximum expectation for the stock to reach $80 within 300 days.

1) Sell 100 shares of GM at $55.90/sh for $5,590 cash proceeds.  (Note tax impact)

2) In an offensive account (tax-free), purchase a 300 DTE (the longest available), 85 delta call option with strike price of $40 for $17.90.  (E1 = $2.00)

3) In the offensive account (tax-free), sell a 300 DTE, 22 delta call option with strike price of $80 for $2.35 (E2 = $2.35).

4) Net cash usage for the position is $17.90-$2.35 = $15.55/sh, or ~$1,555.

5) Considerations:  E2>=E1  ($15.55 + $40 = $55.55 <= current price)

6) IMPORTANT: Notional Consideration: Even though cash investment is only $1,555, this equity should be managed at full notional exposure of $5,590.

7) Cash savings from scaffold spread = $5,590 – $1,555 = $4,035.

8) Account holder invests $4,035 in a defensive account.

  A. Sell an SPX 180 DTE put vertical at the 3-delta level which is 40% below current SPX market value.  This spread has an annual yield of ~4.5%.

  B. SPX index options receive preferential tax treatment as Section 1256 contracts.

  C. Account holder must roll SPX put verticals at ~180 days for continued returns

  D. After-tax financial return on SPX spreads is approximately $137

7) $137 return on 100 shares GM = $1.37 per share

8) $1.37 / $55.90 = +2.4%

9) Benefit of stock substitution strategy is approximately 2.4%

Scaffold Spread: GM

advantages / disadvantages – gm

+ Reduction in cash outlay for position in underlying

+ Risk reduced from $55.90 per share to $15.55 per share maximum loss

+ If losses occur, long strike closes in on ATM price, increasing extrinsic value & mitigating losses

– Maximum realized price appreciation capped at short strike = $80 

– Maximum spread value of ($80-$40) = $40/share, for a gain of $4,000-$1,555 = $2,445 notional

management

SOI recommends a written plan for scaffolding spreads.  This plan should detail parameters for acting on changes in stock price, company strategy, performance, and rollouts.