Well, you give a description and ask "why would this not work" In the dark times (1998) I had a guy from Bankers Trust ask me this over a drink.
Break it into two trades and analyze each one. You get to keep the $50.00 premium if at expiry the stock is between $3.00 and $7.00. If at expiry the stock is less than $2.50 or greater than $7.50 then you start to get into a loss. Will those orders be filled? Limit orders are filled at the price you state OR better. Anything less than $2.99 or greater than $7.01 are not better prices. A Stop Market Order is what you want.
You mean you suggested the strategy or suggested to interview people over a drink? The latter one is a good idea, people are much easier to read when they are drunk
because by the time the stock reaches 7 or 3, the premium on your violated sold option will be like say 1.50 instead of .20, and when you buy or short stock at that point, you'll already be down 150 bucks. That is if you can even get filled assuming its not an overnight gap. It would make more sense to sell this as an iron condor as the hedges are already built into the trade.
Assume that you are holding to the expiration and can ignore P&L prior to expiration. Also, assume that you are doing it on S&P index where you have futures with round-the-clock liquidity. PS. Personally, I thought this was a good iterview question. It requires some knowledge of options theory, at a level nessesary for any options trader worth his seat
I suggested the strategy... Interviewing people over a drink never occurred to me, 'cause I am always painfully aware of how incredibly nerdy it looks. Sitting in a bar, talking about straddles and implied vol, scrawling little payoff diagrams on a napkin, jeez! Imagine the pickup lines!
thanks for the answer....I would never have thought of this as an interview question....shows how old I am, and that I learnt options trading by the seat of the pants and my own notes. (Natenburg helped) While it shows a knowledge of option theory I think I would be more interested in the response showing a lack of knowledge of reality. Depends what the job is for. Because even assuming holding until expiry after you do the first hedge, you get what I suggested in my first response, a complete change of risk profile, that you then have to deal with. ...and how long until expiry remains. If you think you just hedge it and its done then it displays a lack of real trading experience.......which when they are drunk is a great time to find out if they are a cowboy or not. If they are a trainee, it might reveal how much bravado there is. A classic example I remember...... Asian crisis Oct 1997 - crash occured Tuesday I think in Oz - expiry day was Thursday evening......that sorted some people out. The market moved 15% down, and then back up 6% or something like that. Individual stocks were down 20-30%, then bounced back 10-20% - hows the hedging going in an example like this? Liquidity dried up, people were panicking about the downside, when it was the bounce that did the damage... I guess the ability to keep putting these types of trades on all the time makes money. Like most things similar the ability to withstand PL volatility and not being too leveraged at the worst times is important. It takes all sorts to make a market.
And what do you do if it picks your STOP order, then reverses? You will get whipsawed to death with this strategy, since you constantly have to buy/sell shares around the strike.
Bingo! That is exactly the right explanation. Option-theoretic speak would be "a stochastic process can not be integrated locally since it's random at any increment size."