Lessons Learned from Another Option Trade

12/22/2009 12:01 am EST

Focus: OPTIONS

In this previous MoneyShow.com article about a painful option trade, I talked about speaking with an option trader who had exited his long stock position while leaving a short call completely naked. The broker had suggested buying back the obligation and then selling a naked straddle to make up for the loss on the short calls. This is incorrect logic, for this brings exposure, or nakedness, in options trading. Loyal readers know that I am always beating the drum for hedged positions.

While conversing with the trader, I pointed out to him that there was more than one choice to unwind the trade that he had on hand. Together we looked for other choices, because when trading options, there are certainly multiple options/choices. In the situation that the trader had found himself in, it was clear to me that the position was too big and it was controlling him.

In other words, he was no longer thinking straight, and he was not controlling his position. He understood at the conscious level that he had made a major mistake by exiting the long stock position while leaving the calls uncovered, but he could not come up with any other solution to exit the play that was closing in on him. In fact, it was surprising to him that he had not been assigned yet.

The position had gone against him over two points and there were only four trading sessions left until Friday of November expiry. Once again, the underlying was a pharmaceutical stock that was quite volatile.

In Their Shoes

Had I been in his shoes, my first priority would have been the removal of the maintenance by simply buying back the short calls. The idea of buying back the obligation was already discussed, and he was aware of it, so I presented another possibility that involved purchasing LEAPS (Long-term Equity Anticipation Securities). We pulled up all the listed option months for the underlying and noticed that the January (2011) $10 calls were trading at the ask for only $4.00.

Had he bought the stock back to cover his short calls at $12.38 where it was trading, it would have cost him $123,800 for 10,000 shares. Instead, by buying the January 2011 LEAPS, he would save two thirds of the cost. Moreover, he would instantly lift the maintenance requirement. Once again, a simple outward purchase of the stock would cost him $123,800, while the cost of this (LEAPS) long-term option would have been only $40,000. If assignment were to take place, at least he was hedged with a long option.

Purchasing the long-term option for January of 2011 would also buy him some time, just in case the underlying was to go lower over the next four trading sessions. The logic of this horizontal trade is that it is two-dimensional. It is, in the short-term, bearish in its outlook, yet in the longer-term, it is bullish. For him, if the underlying dropped below $10 in the next four trading sessions, it would be perfect. The sold contracts would expire worthless and he would still have the LEAPS until January 2011.

As I presented this to him, he replied full of certainty that the underlying at this point, Monday before the expiry, would not go down below $10. The way in which he articulated these words made it clear to me that his opinions about what the market must do are the same opinions which had brought him into this unfortunate situation.

Two Types of Errors

I believe that there are basically two types of errors that a trader can make: A trading-decision error and a data error. The latter one simply means that, because of platform or some other mechanical failure, the trader at the moment of entry doesn't have sufficient data to make a correct decision.

But in the first type of error, the trader has all the available data present at the time of entry, but they fail to interpret the data accurately. It was clear that this trader had made a trading-decision error and that there was no data error. Being so strongly opinionated often works against the trader.

NEXT: Key Lessons to Learn from This Trade

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Below is the chart of the unnamed pharmaceutical stock. Observe the markings on the chart. The yellow rectangle is the Friday of expiry:


Click to Enlarge

Had he bought the $10 2011 LEAPS and held onto the short calls, they would have expired worthless. By the way, in hindsight, vision is always 20/20, yet on that fateful Monday, he had to decide what was more important to him, lifting the maintenance or something else. He felt that he had to choose between selling the short straddle or buying the LEAPS. That reply sounded to me as if he only viewed the world in black or white.

He could have also attempted to do half and half. Instead of going into the short straddle with 100 contracts, he could have gone into it with 50, and with the other 50 contracts, he could have purchased the LEAPS. In such a case, he could have earned twice as much from the same trade and later on, he could say with clarity which one had been the better choice. Either way, the choice had to be his and not mine. It was his trade. I made all the disclaimers to him beforehand.

In Conclusion

In closing, this is what really happened to the trade. The following is an excerpt from his e-mail to me after the expiry. Some parts of the e-mail were omitted so the trader and the underlying could remain anonymous.

 "… thanks for taking the time to share your thoughts on how to could get out of the mess I created with the stock. You may recall that I had sold Calls with a Strike of 10.00 and the stock was currently selling at about 11.30. I had owned 10,000 shares but sold them so I was in a position where in a couple days I would have to buy them back at maybe 11.30 and sell them for 10.00. What I wound up doing was buying the Calls back at 1.10.

However, as luck would have it, the company announced either late Thursday or first thing Friday that they were going to sell 5 million shares at the price of 9.75. The stock tanked and closed at 9.53. As it turns out, I would have been fine had I done nothing. However, that's the way the market works. Thanks so much for your help."

In conclusion, this article has presented two different endings to a trade, one hypothetical and the other factual. The point is that even if money is lost on the trade, the powerful lessons that could be learned from it should not be lost.

Watch your position sizing and do not let the trade control you at any given time. Stick to your rules and be open-minded to adjust to the trading environment that you find yourself in.

By Josip Causic of Online Trading Academy

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