Belated Resolutions for the New Year

I don’t usually make New Years’ resolution because I rarely keep them. But in my world there are times where you need to reassess how to best deal with the operational aspects of trading options. Unfortunately these reassessments are usually the result of costly mistakes.

Resolution 1: Avoid expiration nightmares!

Always remember that options do not expire on the last day of trading. They exist as a contract until the Saturday following the last day of trading. Take as an example the December 2015 expiration of options on Canadian National Railway. On behalf of clients I had sold more than 60 CNR December 78 calls which were covered by the underlying shares.

On Friday December 18th, which was the last day of trading for the CNR December options, the stock closed at $77.85. That’s an ideal situation! The shares closed just below the strike price. The options expire worthless. Clients keep the stock and for good measure, December 18th was my birthday. The world just seemed…. right!

I got another present Monday morning as CNR shares rallied at the open and remained well above $78 per share throughout the day. I decided to sell the 6000 shares (these were the shares which were covering the now expired short option position) during the day and open a new covered call position with a different underlying stock.

On Tuesday morning our inbox had a notice from our custodian that we were short 2000 shares of CNR. Apparently there was a forced exercise of 20 CNR December 78 calls on Saturday December 19th. So the sale of CNR shares occurred in accounts that no longer held the shares.

We had to enter a buy order for the 2000 short CNR shares on Tuesday morning which was positioned through our error account so as to ensure that no client was harmed.

There are two lessons from this. Just because the underlying stock closes out of the money on the last day of trading does not ensure that short options will actually expire worthless. The holder of the options can force an assignment no matter what the price for the underlying shares at the close of trading on Friday. The second lesson is to ensure that you review all option assignments on the Monday morning following expiration before making any changes to a portfolio.

Resolution 2: Legging into Spreads

Spreads are a common option strategy. They help reduce risk, provide excellent risk reward characteristics and can be used to fine tune one’s outlook for the underlying shares.

The strategy is straightforward; you buy a call or put and sell another call or put with a different strike price and / or expiration date on the same underlying stock.

For example XYZ is trading at $55 per share. You are bullish and decide to buy the XYZ July 55 call at say $3.00 and sell an XYZ July 60 call at $1.00 for a net debit of $2.00 per share. The problem is not the strategy but rather how the strategy is executed.

Many investors attempt to leg into the spread taking one side – either buying the 55 calls or selling the 60 calls – and then “legging” into the other side once the first trade has been executed. The challenge is that the underlying shares can move dramatically when trying to time the remaining side of the trade.

The resolution is simple; never leg into spreads. Always enter a spread as a net debit or net credit. With the XYZ example the order would be entered as a spread with a $2.00 per share net debit. Under this scenario you are indifferent as to the price paid or received for the position only that the cost is no greater than the net debit or credit stipulated in the order.

Resolution 3: Know the personality of your client

Each of us have unique ways to deal with the stresses associated with investing. So much so that one of the fastest growing areas of investment literature is behavior finance that examines how investors react to specific stresses.

One of the more prominent concepts is “Prospect Theory” which looks at how we deal with risk. Studies show that investors react more intensely to a loss then they do to upside underperformance. Effectively the pain you feel from a loss is significantly greater than the gratification you feel when booking a profit. By a factor of 2 to 1 if you believe the surveys.

Applying that theory to options comes down to how you apply specific strategies. For example, using the XYZ spread example, there are two ways to take a bullish position on the underlying shares. You could employ the aforementioned bull call spread where the risk is the loss of the $2.00 per share debit versus the potential of earning $5.00 per share should the stock rally above $60.

However you could also execute a bull spread using puts. In the case of XYZ you would sell the XYZ July 60 put at $6.00 per share and buy the XYZ July 55 put for $3.00. Rather than an initial net debit in the bull call spread you receive a credit of $3.00 per share which is also your maximum profit should the stock be trading above $60 at the July expiration.

In this simplistic example the maximum potential profit from the bull call or bull put spread are equal. Although in reality, assuming the same strike prices, the maximum profit for the bull call debit spread would be ever so slightly higher than the maximum potential return from the bull put spread. That simply reflects the cost of money which at the moment is negligible.

The aforementioned caveat aside, the right option strategy comes down to how you emotionally rank the debit versus credit trade. Are you more comfortable paying up to acquire the “right” to buy shares or do you feel better when you take in the maximum potential profit at the outset while assuming an obligation to buy the underlying shares? While there is no right approach it is important to understand your investment personality. It simply makes you a better investor.

Resolution 4: Limit orders only

A good rule of thumb is to only use limit orders when entering a new option position. Especially if you are dealing with an illiquid market on a specific security. This resolution also has roots in prospect theory. Which is to say the pain you will feel from missing an opportunity as a result of entering a limit order is usually less than the pain you feel from acquiring a bad position because you entered a market order.