Adjusting a 'Trade Gone Bad' - Option Spreads Can be Picked Apart
- Written by Carley Garner
Option Spreads Can be Picked Apart
At this point the only remaining leg of the trade is a short 10,800 call, in which was originally executed as a credit of $400 and is now worth about $850. This represents a $450 paper loss on this leg of the spread. In line with the proverb “have your cake and eat it too”, a trader can hold the short 10,800 call in hopes of the market weakening and thus depreciate in value and add to the overall profit of the trade. Once left with a naked call, a trader should look at the remaining leg as though it were executed for the sole purpose of premium collection. This may avoid temptation for excessive greed or just the opposite, undue fear.
Table 4 If you exited the short call along with the long call.
|Sept. 10,400 call||Long||-$1750||$3225||$1475|
|Sept. 10,800 call||Short||$400||$850||-$450|
|Sept. 10,000 put||Short||$1025||$350||$675|
|Total position debit/credit:||-$325||Total P/L:||$1700|
Although the short call involves risk, it provides a trader with attractive odds. After all, time premium will decay on the option regardless of whether the market trades higher, lower or sideways given that the market doesn’t rally too quick and too far. With a current value of $850, unless the trader expects that the market will rally to 10,885 by expiration, there is little justification in buying the call back. In other words, it only makes sense to buy back the option if the trader believes that the market will be above 10,885 at expiration because this level represents the trader’s intrinsic break-even point based on the value at the time that the long call was offset.
If everything goes as planned this option will lose value and allow the trader to buy it back at a discount. The best-case scenario would involve an impulsive drop ensuring that the 10,800 call expires worthless. If this is the case a trader would have profited on all three legs of the option spread. Let’s do the math, we made $675 on the short put, $1475 on the long call and can potentially make another $400 on the short call for a total of $2550 before commissions and fees ($850 better relative to the timing of the exit of the other two legs which would have netted $1700). Don't overlook the fact that there were three contracts traded and would have created three round turn commission charges.
While this is less than the $3675 ($4000 - $325) maximum payout at expiration, I believe it to be more likely. In order for the original spread to return the maximum payout the market would have to be above 10,800 at expiration. Given the technical climate of the market and the seasonal weakness it doesn’t seem a probable outcome. Additionally, holding a trade too long can often lead to a winning trade turning into a losing trade. Accordingly, I am of the opinion that taking profits one leg at a time reduces a trader’s exposure to the market while increasing their odds of success.