Doc Maher analyzes some trade adjustments.
Have you ever had a position that was not quite working out? Did you wonder if there was something you should do along the way? Or should you ditch at the first sign of a loss? Repair strategies can sometimes save a trade that is not going as planned. However, sometimes it's better close the trade, take the loss, and look for a better opportunity. To read more about repairs, check out Brian Overby's blog series on Butterflies, Part 5: repairing a wayward long call.
This post will cover three different positions, all of which are in the online version of The Options Playbook located in TradeKing's Education Center. The first trade is Play #13 - Long Call Spread, followed by Play #27 - Long Calendar Spread with Calls, and finally ends with Play #29 - Diagonal Spread with Calls.
THE PLAYS
Click here for a larger image.
TRADE FORMATION
On May 6, 2008 Community member 3vilDawg entered the following:
Strike A: Bought to open 1 BMY September 22.50 call @ $1.87
Strike B: Sold to open 1 BMY September 30.00 call @ $0.07
Stock at entry: BMY $23.18.
Long call spread entry: $1.80 debit
Maximum gain: $5.70 (Strike B - Strike A - debit paid)
Maximum loss: debit paid of $1.80
On May 28, 2008, the following adjustment was made:
Strike B: Bought to close 1 BMY September 30 call @ $0.04
Front-month Strike A: Sold to open 1 BMY June 22.50 call @ $0.44
Back-month Strike A: Long 1 BMY September 22.50 call @ $1.84
Stock at adjustment: BMY near $22
Long Calendar Spread with Calls: $1.40 debit
Maximum gain: BMY near $22.50; not enough information to determine
Maximum loss: debit paid of $1.40
On June 23, 2008, the next adjustment was placed:
Front-month lower strike: Sold to open 1 BMY July 20 call @ $0.40
Back-month higher strike: Long 1 BMY September 22.50 call @ $1.40
Stock at adjustment: BMY near $19.70
Diagonal Spread with Calls: $1.00 debit
Maximum gain: BMY near $20; not enough information to determine
Maximum loss: $3.50 (22.50 Strike - 20 Strike + debit)
ALL-STAR COMMENTARY
I was reading 3vilDawg's post about repair strategies on a Bull Call Spread (a.k.a. Long Call Spread). I have never been a big fan of these because they usually involve adding more money to a trade in order to give it a chance to do what it didn't do in the first place. However in this case, 3vilDawg is trying to "repair" his trade by reducing his cost basis. In this entry I'll review his position and what he did to fix it.
3vilDawg tells us that on May 6th (coincidentally my birthday) he was bullish on BMY. Here is the chart as of that day:
Click here for a larger image (May 6th).
Ok the first thing that you might notice is that he sold a $0.07 call. This was the trader's first mistake. The amount the debit was reduced ($0.07) is not enough to warrant the cap set on the upside potential of the spread. Here is the P&L chart:
Click here for a larger image.
On May 28, BMY looked like this:
Click here for a larger image (May 28).
At this point the September 30 call was bought back for $0.04. Even though this gained $0.03, it was a net loss with commissions. The September 22.50 call was worth about $1.07 on May 28. So if he had just closed the position at this point he would have recovered approximately $1.10 out of the initial debit of $1.80 before commissions. This is where I would have quit and looked for a better opportunity elsewhere. However the trader's outlook had become neutral so a calendar looked like a good way to recover the loss of $0.70.
The next trade was to sell the June 22.50 call for $0.44. The problem here is that the $0.44 the trader gets is not going to make up for the already mentioned loss of $0.70. Plus there will be another month of time decay on the September 22.50 call. What's more is the trader is exposing himself to another month of risk. If BMY were to move up or down even slightly, the trade would lose more. It seems like the upside does not justify the risk.
Here is BMY on June expiration:
Click here for a larger image (June 20).
BMY is now down to $19.57 and so the June 22.50 call expired worthless. The $0.44 is kept. However the September 22.50 call is now down to $0.25. So it went from $1.10 to $0.25 and lost $0.85. The net for this adjustment was +$0.44 - $0.85 = -$0.41 loss before commissions.
Next he sold a July 20 call for $0.40. This creates a diagonal calendar spread. Although additional premium is collected, more risk is taken on. If BMY goes back above $20, the position will lose because the short July 20 call will be in-the-money, but the long September 22.50 call will be out-of-the-money.
Click here for a larger image (June 27).
By June 27, BMY was back up to $20.30. The September 22.50 Call was up to $0.40 (+$0.15) but the July 20 Call he sold was up to $0.67 (-$0.27). BMY won't have to go up much to put this trade at a loss. So again I don't like the upside versus the risk.
If all goes as 3vilDawg planned, he would sell another call in August for another $0.40. By September expiration he would have reduced his cost basis to $0.60. Of course at this point the September 22.50 call is also worthless so the loss would be $0.60.
Now let's go back and look at where we were on May 28. We could have exited this trade for a $0.70 loss. However the trader stayed the course just to hopefully lose $0.60 after four months instead of $0.70 right away.
The trader showed great dedication in sticking to the trade. However I expect 3vilDawg has learned some valuable lessons. Sometimes experience is the best teacher. The point is to be very careful and examine the strategy and repair that you employ. Make sure that it makes sense from a risk/reward and time perspective. In this case the calendar strategy was wrong from the beginning. You could only collect $0.40 per month for three months, giving you $1.20 in premium. The September 22.50 call price was $1.10 at the time of the first adjustment. Best case scenario would be to earn $0.10 after four months of time.
Repair strategies can work if the conditions are right, but sometimes it's just better to give up, move on, and put your capital to better use. Thank you 3vilDawg for blogging about these trades. You have provided some great examples and many topics to discuss. Better luck to you in your future trades.
"Income Trader"
Doc's previous posts: Managing Credit Spreads and Should Runningpair trade Leap Calendars?
For a list of previous All-Star Trades, please click here.
Would you like your Trade Note to be chosen? Read more.
Nicole Wachs contributed to this blog.
Options involve risk and are not suitable for all investors.
Please read Characteristics and Risks of Standardized Options.
Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
Jonathan F. Maher, PhD has a professional business relationship with TradeKing.
