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When a Good Call Spread Goes Bad
11/23/2011 7:00 am EST
Traders shouldn’t instinctively rush to try to “fix” a call spread gone bad by buying the underlying equity. As this example shows, sometimes it’s best to take a partial loss and move on.
Sometimes it appears that a short vertical call could be “fixed” to minimize a loss by going long the stock. This article is going to examine both the advantages and disadvantages of this fix.
By the end, a trader will see that it may be better to use an alert and apply technical analysis to the underlying and decide if it is just time to simply close the spread rather than attempting to repair it with a long stock purchase.
For example, if the Powershares QQQ Trust (QQQ) is trading at $58, and technically it appears to be creating a double top, a trader might select a bear call spread as the correct strategy.
The trader’s bias is bearish due to the high probability of the double-top play. In other words, price action frequently fails to break on the first attempt through the level of resistance, in the case of QQQ, at $58.
Assuming that the trader has placed a bear call in which the $58 at-the-money (ATM) leg was sold and the $59 out-of-the-money (OTM) call was bought for protection, the risk is limited, so there probably will not be the occasion to need to fix. The trader’s outlook is bearish and the forecast predicts the QQQ price action closing below the $58 strike price at expiration.
Let us assume that for the first several days, the trader’s forecast is dead on and the price is trading below $58, creating a bunch of doji (sideways) action, and then all of a sudden, huge value kicks in and a rally takes place.
The short vertical, which was sold for a small credit, would now cost so much more to be bought back due to the price of the underlying being inside the spread, somewhere between $58 and $59. In this case, the short leg is in the money (ITM) while the long leg is just approaching the point of being near the money, or ATM. A trader at that point could elect to buy 100 shares of the stock to hedge the position.
The trader’s reason for going long QQQ above $58 is because QQQ is no longer bearish, but bullish, and if expiry comes, then the long 100 shares would cover the sold call contract of the 58 leg. After these cancel each other out, he could, assuming that the QQQ is well above 59, exercise his right to purchase QQQ at $59 with his long call.
This is faulty thinking, however.
NEXT: Why It's Best to Just Minimize the Loss in This Case|pagebreak|
If the price action lifts and stays above $58, it means that the double top in the $58 area has failed. The bearish vertical spread should be altogether exited and then a new bullish trade could be initiated rather than leaving a bearish option trade on while placing the long bullish bet on the stock.
The key point to remember here is that fixing a losing trade can only be done by placing a winning trade—period. Sometimes it is better just to close the losing trade rather than try to fix it. If the price action is above the sold strike price of $58, it is probably not best to buy the stock, but just get out of the spread for a loss.
Keep in mind that a loss can be quantified in two categories: The maximum loss, which is known to the spread trader from the moment of entry, and any amount lesser than the max loss. Hence, the choices to the trader are: Take a partial loss or take a max loss.
Also, keep in mind that many times the price action could touch the 58 sold leg and even temporarily trade above it—but not for long—and then pull back below $58. Hence, the decision for closing the spread should be made after technical analysis has been done.
In order to have the time for technical analysis before actually closing the spread, we suggest the use of alerts. When QQQ trades at or above $58, an E-mail, phone, or text message is sent to the trader automatically from the trading platform. Having the alert instead of a blind conditional order could be better.
A conditional order would specify that when QQQ is trading at or above $58, simply close the spread at whatever the market price is at the time. In such case, both legs are exited and two commissions are paid. The transaction debits the trader’s account and the overall trade is closed for a loss, which is calculated by subtracting the credit received in the initial spread from the debit paid when closing the spread.
The conditional order (called contingent in some platforms) would only be preferred, however, if the trader will be on a plane, in a meeting, or otherwise away from their trading platform for too long to be able to act upon any alert received.
In conclusion, rather than trying to fix a credit spread with stock, it may be better to have an alert on as opposed to a blind conditional order. Then a trader would have the necessary time for proper technical analysis before deciding to close a losing vertical credit spread.
Too many times, the price action could go up to the short strike level, take out your spread with the conditional order, and then just go back down right after. We are trying to avoid getting knocked out by this action. Besides, a vertical credit spread has quantifiable, limited risk.
By Josip Causic, instructor, Online Trading Academy
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