Let’s look at how the position is affected at expiration in three different scenarios: The stock goes up, goes down or stays flat.
Up: This is where the 1x2 strategy works best. You would now have double leverage on the stock from 50-55. The upside exposure comes from the stock and from the long 50 call. Because we financed the purchase of the 50 call with the two 55 short calls, we gain the same on the call as we do the stock. However, profit is capped at 55 if the stock continues to rally.
Down: Should the stock decrease in value, all the options will expire worthless. Because there was no additional risk added by employing the 1x2 ratio, the risk is present in only the 100 shares of stock you are long.
Sideways: Should the stock stay the same, the options also would expire worthless. It would be a break-even trade (minus commissions).
The above table compares the 1x2 ratio spread to a traditional averaged down position at expiration.
It is important to note that there is time value in those 55 calls. You will not have the double exposure in the 1x2 until expiration. So, like a covered call, if you want the full premium, you must be patient.
This strategy will allow you to grab a little more upside (up to your short calls) without adding additional risk to the downside when a trade intially goes against you.
Mike Tosaw is a portfolio manager at Know Your Options Inc.