To Bail or Not to Bail Early
02/05/2014 8:00 am EST
Sometimes it’s necessary to adjust your position or close out a trade early, but it’s important to distinguish between a change in plan based on a true change in circumstances and just chickening out, says options expert Russ Allen of Online Trading Academy.
In last week’s article, I discussed methods of locating options opportunities. I wrote that we can either approach the search from the standpoint of stock price or of implied volatility.
First, a quick note about that article: I received quite a few emails asking about an indicator that was part of the scan, the average true range as a percent of price. I use this to compare the daily average price range of the stock to its price. Stocks that move, on average, in a range that represents from 1% to 8% of their price, are good trading candidates. Less movement than 1% per day means that they don’t move enough to be interesting. More than 8% per day, on the other hand, means that they move so much that their movement is likely to be chaotic and unpredictable. This particular indicator is a custom one provided to students in our Extended Learning Track graduate program. If that’s not available to you, a substitute would be beta, which is widely available. A beta of 1.0 means that a stock has volatility about the same as the benchmark, which is the Standard & Poor’s 500 Index. For scanning purposes, a beta value between 1.5 and 3.5 should capture roughly the same population as the custom indicator.
I described scanning for stocks that are at an unusual level of implied volatility, and designing a trade to benefit from an expected return to a more normal level. (Implied volatility is a measure of the level of market expectations for price movement of the stock. The more movement is expected, the higher the Implied Volatility of the stock).
Searching on January 24 for stocks that were at unusually high levels of volatility, I found LKQ Corporation (LKQ). LKQ’s stock had just taken a big dive, into a strong demand (support) area, as we can see on this chart as of 1/24:
The stock had fallen into a base area between 25.38 and 26.89 that had formed in July and August of 2013. A scan of the news showed that the company, a supplier of aftermarket auto parts, was being sued by Chrysler for patent infringement. The company claimed that it was not guilty, and that if Chrysler won, the amounts would be immaterial.
Since this is just the type of thing that can cause a big overreaction in markets, chances for a rebound from this drop appeared good.
Implied volatility was very high, a consequence both of the unfavorable news, and of the impending earnings release, scheduled for January 30. With IV so high and a bullish outlook, we chose a bull put spread.
Since it appeared that the support above 25 was holding, we elected to sell the February 25 puts, which brought $.75. For protection and to reduce buying power requirements, we simultaneously bought the February 20 puts at $.20. Our net credit, and maximum profit, was $.55 per share, or $55 per contract.
Our maximum theoretical loss would occur if LKQ fell below $20 at expiration. In that case, both the 20 and the 25 puts would be in the money. At expiration each would be worth exactly the amount by which it was in the money. Since their strike prices were $5 apart, the 25 put that we were short would be worth exactly $5 more than the 20 put that we owned. We would therefore have to pay $5 per share to extricate ourselves from the trade, in the event that LKQ did finish below $20. Subtracting the $.55 per share credit that we received earlier, that would leave a net loss of $4.45 per share, excluding commissions. This $4.45 maximum loss was the amount of margin required to enter the trade.
NEXT PAGE: Why He Bailed Out Early|pagebreak|
Of course, we did not plan to hold on to this trade all the way down to $20 per share. If the January 22 low of $25.27 was breached, we would plan to unwind this trade immediately. This would result in a small loss or a small profit of about $50 or less, depending on how long it took for that drop to happen. If that drop had to happen at all, the longer it took, the better, since we were short time value. We put in orders to unwind this trade, at the market, if LKQ dropped below $25.00.
The real risk here, as in all short option positions, was that the stock price could have an overnight gap against us. In the worst case, it could open below $20 after closing the previous day above $25. That would give us no opportunity to unwind the trade at our stop price of $25, and we would be stuck with the maximum loss. We considered that chance very slim, since the bad news was already out and the stock had firmed up.
Near the end of the day on January 29, the day before the earnings announcement was scheduled, the stock had held up well and had been as high as $27 during the day. However, after re-checking the charts and the news, the trade now did not smell right, for these reasons:
Instead of bouncing energetically off the support level, it was basing near it. There was not much cushion above the $25 short put strike.
Two officers filed notices of sales of a fair number of shares on January 25, just ahead of the earnings. This is not unusual in itself, but it was another piece of a picture that could spell trouble.
The company released an 8-K filing on January 27, re-releasing earnings numbers for the past three years and discussing reshuffling of their debt. Also not disturbing in itself, but not reassuring.
As of the end of the day on January 29, the expected earnings announcement date of January 30 had not been confirmed by the company. Were they going to re-schedule it? If so, why?
Based on these factors, I decided to unwind this trade before the earnings announcement. The 25 put was bought back for $.50 and the 20 put sold for $.20, for a net debit of $.30. Subtracting this cash out from our original credit of $.55 left a small profit of $.25 per share on the trade. After commissions of $1.00 per contract in and out on the two separate puts, this was $.21 per share. This $.21 on $4.45 of buying power amounted to a profit of 5% in a week, which was nothing to sneeze at.
In this case, I bailed early on a trade, without letting it run its full course. This was as a result of new information that changed the picture materially. It’s important to distinguish between a change in plan based on a true change in circumstances, and one that is just chickening out. Here, I believed that there was a strong circumstantial case that the picture had truly changed. By the time you read this, we will all know whether bad news was impending or not. In any case, I believe that it was the right call here.
By Russ Allen, Instructor, Online Trading Academy