The Fig Leaf Fell Off

TradeKing Sr. Options Analyst Brian Overby fields a question from the Trader Network from an options trader whose spread hasn't gone as planned.

Some trades just go bad on you, plain and simple. While nobody likes the pain of losing money, it's only a pure loss if you don't learn from the experience. This is the question posted in the Trader Network forums by HomeBrewer: 

"Hi all,

I'd like to hear some of your opinions on how to manage a "Fig Leaf" position on E*TRADE (ETFC). To summarize, it is similar to a covered call position, but the 'underlying' is another long term call instead of actual stock.

I currently have two positions that I opened with LEAPS that I have been selling front month calls on for a few months. I've reduced my cost basis decently, but now I'm in an awkward position. In an attempt to continue capturing premium, I sold (at the time) at-the-money calls. Now, the short calls are in the money, and if I closed out the position it would be a net loss.

I'm looking at rolling out and up, but it seems I can only do this for a debit (unless I go several months out), which I'm not particularly fond of (in the event we have another pull back). The short calls expire in 11 days.

Thoughts? I'm leaning towards biting the bullet and rolling out for a debit to continue to maintain my overall position, but possibly waiting until next week (expiration week) to roll."

Hello HomeBrew,

Your questions prompted my own question, what was the Delta of the bought LEAPS call option when the trade was executed? The Fig Leaf strategy, as it is written in the options playbook, wants the delta of the long term option to be .80 or greater, which means the option had to be deep in-the-money (ITM) to have that high of a delta. If that was the case the position would most likely be profitable if you took the entire position off (unwound) the trade. The bought option must have been had a delta lower than .80 maybe around .60 - .65 is my guess. The reason I think so is because you stated the entire position is at a loss right now and both the options are in-the-money. In most instances this would not be the case if you bought at least an .80 delta LEAPS call and sold a near-term at-the-money call (around .50 delta) against it. So this really is more of a diagonal spread in this case. (The max risk at the front month expiration is limited to the debit paid for the trade.)

Volatility Crunch

To speculate as to why the position is at a loss, I would guess that there was a volatility crunch that ended up lowering the value of the bought LEAPS call option. Many LEAPS option traders don't realize the susceptibility to fluctuations in implied volatility (high Vega). At-the-money LEAPS options are very susceptible because of all the time premium they contain. The deeper the option is in-the-money the more of the value of the option in made up of intrinsic value and less of it is time value. This is the reason the fig leaf requests the delta to be .80 or higher, you have to get pretty deep in-the-money in most cases to have the option trade with such a high delta.

Was the VIX near 30 when the trade was entered (now under 20)? Was it placed around the time that all the news on the Euro debt crisis was coming out?

What's Next

With all that said, bottom line is you have a loss on our position and you are asking what you should do now. If you still want to remain in the position and roll the short call up and out - you pegged the answer in the initial question above. You have to either pay a debit to roll up with a short term expiration or look to a longer term expiration for a possible credit. There is no secret way to roll if the stock has gotten away from you. Also, I would roll sooner rather than later (if you're expecting the stock to keep its bullish tendencies). Right now price movement of the underlying is more of a factor than the 11 days of time value that is left in the sold front month call.

In the playbook there is a section called "how we roll", it explains in detail the concept of when and where to roll a short call option.

http://www.optionsplaybook.com/managing-positions/rolling-covered-calls/

The one thing I would highlight in this section is the Option Guy Tips at the end of the short put rolling section. This section is quoted below...

"As an option you’ve sold gets in-the-money, you’ll have to quickly decide whether or not you’re going to roll. As a general rule of thumb, you may want to consider rolling before options you’ve sold reach anywhere from 2–4% ITM, depending on the value of the stock and market conditions (e.g. implied volatility). If the option gets too deep ITM, it will be tough to roll for an acceptable net debit, never mind receiving a net credit.

You may want to consider a 'pre-emptive roll'. That is, you can roll before the option gets ITM if you think it’s headed that way. This might lower the cost of buying back the front-month option, and could result in a larger net credit for the roll."

Addition reading material

Here is a very good blog that really shows how a large drop in implied volatility can really hurt a long term option that has been bought.

Lastly, when the stock is at this low of a price I would really think hard about just buying 100 shares vs a long term option contract. One last blog to read on that topic - options on inexpensive stocks.

Regards,

Brian Overby

TradeKing Options Guy and Senior Option Analyst
www.tradeking.com

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Disclosure: Brian Overby does own shares in EFTC.

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options available at http://www.tradeking.com/ODD.

Multiple-leg options strategies involving additional risks and multiple commissions and may result in complex tax treatments. Consult with your tax advisor as to how taxes may affect the outcome of these strategies.

Implied volatility represents the consensus of the marketplace as to the future level of stock price volatility. Delta represents the consensus of the marketplace as to the theoretical price movement of the option relative to the underlying security.  There is no guarantee that these forecasts will be correct.

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