12/18/2009 12:01 am EST

Focus: OPTIONS

In this article, I will go over three possible outcomes for a bear call spread at expiry. Those scenarios involve the price of the underlying closing within the spread, above the sold call, and below the sold call.

I have included the chart here, as I usually do for my real trades, but I chose to white out the exact ticker. Thus, when referencing the underlying, I will use that worn out cliché of XYZ.

The daily chart of XYZ below shows (with a blue oval) the point of the initial entry. I have also marked on the chart in green letters the words, "Long Entry." It is at this point that the student went long. In hindsight, we could observe that from the technical analysis viewpoint, XYZ at the time of the entry was coming to resistance, yet that was the exact place where the student went long.

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The initial trade on XYZ involved going long on a March 14 call, while XYZ was hitting resistance, as I pointed out above. At that time, the premium for the calls was high, but as soon as XYZ started to head south (way south!), the call premium got cheaper.

The next point, marked on the chart with a dark blue oval and the word "Spread," is where the student has added more contracts to the existing position and then turned it into a spread trade. This action of averaging down is something that we, the instructors at Online Trading Academy, strongly discourage, for even if it works out occasionally, the strategy of averaging down creates a bad habit that is difficult to break later on.

The final outcome of turning it into a bear call has produced the following trade:

BTO + 100 Mar 14c @ -0.505 (OTM)
STO – 100 Mar 13c @ +0.70 (ATM)
Max P (is the difference) + 0.195
Max L (width Spread 14c-13c) 1.00 –Max P
Max L -0.805
ROI = Max P/Max L = .195/.805 = 24.2 %
BEP = sold strike + Max P = 13.00 + 0.195
BEP = 13.195

Oddly enough, the moment the student had turned his initially bullish trade into a bearish trade, the market had reversed and started rallying up. Now the trader is sitting in a trade that he completely does not understand. Moreover, due to the huge contract size, the broker has placed the maintenance on his existing position, in this case \$10,000. This is a huge chunk of change to be sitting unused.

Having presented all the facts, let us go over three possible outcomes that could take place at the expiry. They are in fact simple and Figure 2 provides the visual representation of them.

Once again, I hate oversimplifications, but often when explaining something, it is useful to use them as a starting point. Now let us turn our attention to each of those three scenarios and dig a bit deeper into them.

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Bottom line = + 0.195

The best possible outcome, keeping the maximum profit (Max P) or 0.195 and the maintenance on our account is lifted after the expiry.

Scenario # 2 (Bad outcome) XYZ \$14.9

Bottom line = - 0.805

With the price at \$14.90, the sold 13c is now worth 1.90 and it needs to be repurchased for a much higher price than what was sold. Observe that it was sold for 0.70 cents and now needs to be bought back for 1.90. In this case, the loss is 1.20 per contract.

However, the trade has gone sour, but the max loss isn't 1.20 because of the fact that the 14 call, which was bought for 0.505, is now trading for 0.90; so once the 14 call is sold, the profit of 0.395 is received and needs to be subtracted from the 1.20 loss (caused by the sale of the strike price of the 13 call). Therefore, the loss is actually - 0.805.

Bottom line = - 0.045

When all the calculations are done, the loss is basically less than a nickel per contract. The reason why that would be the case is the following. The break-even point (BEP) was 13.195 and the price has closed at 13.24. When the bigger number is subtracted from the smaller one (the closing price minus the BEP), or 13.24 - 13.195, we get the loss of only 0.045, which is small.

Now keep in mind that one contract controls 100 shares and the student has 100 contracts, which is basically 10,000 shares. This means that the loss, which seems small at first, is in fact \$450 plus the commissions. Once again, be aware of the position sizing when trading options. Leverage is a two way street, it can work either for you or against you.

In conclusion, this trade is still open and it is in play until the expiry. Which way it's going to unfold remains to be seen, yet as of now, we could learn from the student's pain. The saying goes: "Wise trader learns from his or her mistakes, but the wiser one also learns from the mistakes of the other traders."

Please do not look down on other fellow traders; learn from their mistakes. Even if you lose money on the trade, do not lose the valuable lesson that the trade had. Go over your bad trades and learn from them. It is painful, but it is worth it.

So how can we best fix this trade?

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The first one is closing of the March bear call and simultaneously rolling it into another spread in April. At this point, the trader has a choice of completely reversing the market outlook from being bearish on the market to being bullish on the market. The student whose trade I discussed in last week's article is now more concerned than ever, and the conviction of the student is that the market is still going to go lower.

Therefore, honoring the student's P.O.V. (point of view)—after all, it is the student's trade—I will look into replacing the existing March bear call with the April bear call in an attempt to salvage the trade, or whatever is left to be salvaged.

Let us dive into the specifics.

This is the current position that the student has:

BTO + 100 Mar 14c @ -0.505 (OTM)
STO – 100 Mar 13c @ +0.70 (ATM)
Max P (is the difference) + 0.195
Max L (width Spread 14c-13c) 1.00 –Max P
Max L -0.805
ROI = Max P/Max L = .195/.805 = 24.2 %
BEP = sold strike + Max P = 13.00 + 0.195
BEP = 13.195

As it could be observed, the break-even point of 13.195 was approximately where the student changed his bullish stance (of owing just long March 14 calls) into the bearish stance, turning his long call into a bear call by selling against the March 14 call the lower-strike price, March 13 call.

At that point, the student has received both the credit for 0.195 times the number of contracts that were involved in the transaction. At the same time, the student had a huge maintenance placed by the broker until the expiration. In the last article, I chastised the student for the position sizing; hence, in this one, I will leave this issue of oversizing out of the discussion.

Having recapped the facts, let us go back to the original question: "How can a bear call gone bad be fixed?" It all depends on where the market is and how many days are left until expiry. Why do I say, "How many days are left until expiry?" Within the week of expiry, traders are no longer in charge of their positions. Let me get more specific: During those last three or four trading sessions, the market makers could widen the spreads for those traders who are trying to get out of their losing positions for the front month.

Let me ask the readers, on whose side is time during that period? Is it on the side of the traders whose trades had gone bad, or on the side of the floor traders who have to be there until 16:15 EST regardless of whether the trades are coming through or not? What do you think?

It is during those three or four days before expiry that the traders are at the mercy of the market makers? (In one of the subsequent articles, I will come back to this point and elaborate on it to a greater extent.)

Besides knowing how many days are left until expiry, we also need to know specifically where the market is for the product that we had traded. In our example, the student has entered this position around 13.20, and since then, he has passively monitored his position as it was going against him.

At the moment of writing this article, the product, which we should again call XYZ, was trading at 14.60, which would be one dollar and 40 cents higher than where the bear call was entered.

Now, let us go back to using one of those charts that I had created last week. In the case of price being at 14.60 on the day of expiry, the student would have the maximum loss, or scenario number two, which we'll now explore in greater detail.

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Scenario # 2 (Bad outcome) XYZ \$14.6

Bottom line = - 0.805

With the price being at \$14.60, the sold 13 call is now worth 1.60 and it needs to be repurchased for a much higher price than what was sold. Observe that it was sold for 0.70 cents and now needs to be bought back for 1.60. In this case, the loss is 0.90 per contract. However, the trade has gone sour, but the max loss isn't 1.60, because of the 14 call that was bought for 0.505. It is instead 0.805 (times the number of contracts involved in the transaction).

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Figure 1 above shows the option chain for the March at the time of writing this article. Look at the price for the March 14 and 13 calls. Observe that I have circled the price which needs to be paid in order to exit both of these positions.

Bottom Line: Loss = - 0.555

Where is the fix? The fix would come at the simultaneous repurchase of March and sale of April bear call. Again, going back to the student's stance: "The market will go down! If not by March expiry, then by April's expiry!" Hence, let us simply exchange the months, keeping everything else in place. Figure 2 below shows the option chain for April.

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The outcome is:

BTO + 100 Apr 14c @ -1.00 (OTM)
STO – 100 Apr 13c @ +1.65 (ATM)
Max P (is the difference) + 0.65
Max L (width Spread 14c-13c) 1.00 –Max P
Max L -0.35
ROI = Max P/Max L = .65/.35 = 186 %
BEP = sold strike + Max P = 13.00 + 0.65
BEP = 13.65

The numbers mathematically might look appealing, but let us stay grounded in reality. If the student closes his March bear call for the loss of – 0.555 and then receives + 0.65, producing the difference of + 0.095; how much of the profit is there? The March loss and the April premium get subtracted, while the same maintenance on his account is in place, which is huge, \$10,000.

Now, is it worth it to have such a big chunk of money sitting in maintenance for the entire month? This is the question that the student needs to answer. Moreover, XYZ must close below 13 in order for the maintenance to be lifted. Is it worth it to prolong this bad trade?

In conclusion, I was asked to provide one of the possible scenarios for fixing a bad bear call. I presented a "rolling out" strategy without suggesting that it is a good solution. Notice, in this article, there are no charts and no technical analysis. It is all mathematical calculations of the possible losses.

Lastly, let me leave you with the final thought: This strategy of prolonging the taking of loss could go on indefinitely, month after month, year after year. But keep in mind, "What is the goal of trading? Avoiding something or making something?"