You are generally correct in thinking that this strategy should make money most of the time, however I would warn you to be very careful with strategies that earn a small amount of money most of the time but lose many multiples of that when things go wrong. These are examples of “picking up pennies in front of a steamroller”. The options market is full of these strategies. Here are some other risks and drawbacks:
You will probably need to sell many more calls than you bought to
achieve your desired greeks (flat gamma + receiving a credit). I
suggest you pull up option quotes on yahoo finance and see what
ratio is needed yourself. One example I found is buying the Apple
Aug 20th 160/175 1x3 with Apple trading \$136. You can buy this call ratio and receive a credit of 0.10. Increasing the ratio
makes your drawdown when the stock actually moves up significantly
worse. In my Apple example you would make ~0.02 (\$2) each week if
the stock didn’t rally significantly but you would lose ~5.5 (\$550)
if the stock ever rallied to \$175. This would wipe out 275 winning
trades in a row!
If your plan is to roll the option strategy before it expires the
underlying does not need to move as much before you start losing
money. Below is a chart I created using the Apple example above and
this tool. Notice that even if you close the strategy in one week
you will start drawing down much sooner than the expiration payoff
would indicate.
- The amount of theta the structure collects in one week may not be
enough to cover execution costs. Let’s look at our example, we
collected 0.10 (\$10 per 1 structure) and since you are planning on
closing it in one week we should only expect to collect a fraction
of this if the stock stays in the same range. Let’s make the
incorrect assumption it will linearly decay for simplicity's sake.
This means we will get 7/52 * 0.10 in theta after one week since
there are 52 days until the expiration date. This only ends up being
0.0135. My broker charges about \$2.5 per trade in an options structure like this. That means we would have lost money entering
and exiting the trade in one week (\$5 in commissions vs \$1.35 in
theta).
- There is a chance the implied vol surface reprices in a way that you
lose money over one week even if the stock does nothing. This means the implied vol of the calls you sold went up
significantly relative to the call you own.
- Since there is a possibility of unlimited loss with this strategy
your broker will likely charge a hefty initial margin to hold the
trade. My broker would charge me $2,750 for one structure using the
Apple example. This means from a return on capital perspective the
trade isn’t very good. Even if we made 0.02 every week the
annualized return on capital would be something like 3.8% which is
poor for a strategy with unlimited loss potential.
I highly recommend you go through checking the payoff diagram, return on capital, and execution costs with some real world data to build your intuition further. Lastly, you will be able to find opportunities that look better than my example, however it may be because the drawdown begins sooner, the ratio is higher, or the market believes a sharp move up has a higher probability than my example.
