Figuring Cost Basis, and the advantages to rolling the short side of a Call diagonal

1-7-08

I’ve got some catching up to do with my trades, and a bunch of notes that I’ve taken about understanding diagonals.

Let’s start with AAPL (Apple). This is Mojo’s blog at insanemoney.com on this trade - Mojo has been teaching me about Options, so I’m following his trades:

------------------------------------------------------------------------------

"OPEN: AAPL LEAP Jan 09 150 Call -69.15
31st December 2007, 12:54 am
We’ve been watching Apple (AAPL) for quite a while and we’re looking to purchase a Jan 09 leap. We’ll probably purchase the Jan 09 150 call for a debit of -69.50. With the stock being at 199.83 that means the -69.50 is made up of 49.83 of intrinsic value and 19.67 of extrinsic or time value. There are 383 days until expiration so that means our daily time decay will cost us $0.051 a day.
Now you know me, I never hold a long call or put by itself so we’ll likely roll this into a call diagonal by selling the ATM Jan’s. Currently the at-the-money (ATM) call is the 200s selling for +8.95. Since this is slightly out-of-the-money this is all extrinsic or time value. With 19 days left to expiration that will give us a positive time decay of $0.471. So, we’re spending $0.051 a day to bring in $0.471 a day! Sweet!!

We will update you once we’ve move to sell the short side.
Mojo

PS - OK, we got filled at a debit of -69.15. We think with the potential of a near term split, people moving their cash holdings from closing losing trades, and the relative strength of Apple today, we are going to hold our long position and see what happens on Wednesday."

insanemoney.com

----------------------------------------------------------------------------

So we sold the Jan ’08 195s @ $8.65 and bought the Jan ’09 150s for $69.15.
To figure the Cost Basis (CB) you take what you bought the ’09 150s for ($69.15) minus what you made by selling the ’09 ATM (at-the-money) 195s, which equals a CB of $60.50.

$69.15 - $8.65 = $60.50 CB

So this was our CB on our original buy long, sell short.

The market didn't go up like we thought, but what can you say... that's the market for ya. So today we did some managing of our account by rolling the Jan ’08 195s for the Jan ’08 185s because AAPL has been tanking. By doing this we had to buy back the Jan 195s for $4.40, and we had to add this cost back to our CB of $60.50, bringing it back up to $64.90 (we did this because we originally sold the Jan ’08 195s for $8.65 and booked that credit against our cost, but now that we bought it back we can’t claim that as a credit anymore, so we add it back and bring our CB back up the amount that we bought it for).

Now we’re at $64.90, and now we go back out and sell the ATM call, which is now the Jan ’08 185s (because the price of AAPL has been going down) for $8.32. And now we can subtract the $8.32 from our $64.90, which gives us a new CB of $56.58.From this you can see that by managing our trade, we’ve in effect reduced the CB for our Jan ’09 150s another $3.92. So even though we would like to see the AAPL stock stay natural, go up, or even go down just a little bit, it has gone way down but we’ve still been able to move defensively and affectively continue to reduce our CB.

Now we need to keep in mind that we can do this because we have a lot of time left on our Long Jan '09 call. A lot of time left to continue to reduce the cost to us for that call. It’s like we bought a house for $150K (our Jan '09 call) and we are using the money we make by selling the ATM calls like they were renters paying our mortgage and in effect slowly paying off our house (i.e. the ATM calls are reducing our CB – the cost of the house)