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Understanding How to Exit before you Enter

Richard Croft
May 19, 2015
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5 minutes read
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Option trading is rarely static. Cost / benefit metrics can change quickly causing one to rethink whether the initial assessment underpinning a trade is still in play. Often follow up strategies are required to either minimize losses on trades that miss the mark or up the ante on profitable positions.

Ideally, follow up strategies should be set out before any new position is established. It’s important to establish a range of outcomes and what steps might be taken should the underlying security realign beyond initial expectations.

For example, let’s assume that three months ago, XYZ was trading at $23.50 per share. At the time, we will assume that XYZ August $25 calls were trading at $2.00 per share. A six month covered write would yield 16.3% if XYZ is called away and 9.3% if the underlying remains the same. Downside breakeven is $21.50. Decent metrics assuming you are mildly bullish about the short term prospects for XYZ.

Fast forward three months and XYZ is trading at $29 per share. Analysts have upped their price targets and the XYZ August $25 call is trading at $4.50. Most traders do not enjoy the positive experience of earning the maximum potential return. Instead, traders focus on the risks that underpin covered call writing. Which is to say, you lose the best performing stocks in your portfolio.

The XYZ example raises three very basic questions; 1) was your initial assessment that lead to the sale of the covered call reasonable? 2) has that assessment changed because of market or company specific conditions? and 3) are there follow up strategies that could be implemented to enhance the returns from the original position?

Follow up strategies come in two forms. There are repair strategies designed to minimize potential losses and enhancement strategies designed to increase the potential profit from a position. In this case circumstances dictate the latter approach.

The most common tactic is to roll up the covered call to a higher strike with either the same or longer dated expiration. In this case, re-purchasing the initial August $25 call at $4.50 and selling say the XYZ August $30 call at $1.00. The total cost to roll up the position is $1.50 (i.e. $2.00 + $1.00 from the sale of the two calls less the $4.50 cost to re-purchase the initial call).

The new covered write ups the potential return to 33.3% if the stock is called away or 28.9% if the stock remains where it is. But at the same time, it raises the downside breakeven to $22.50 per share.

An alternative to the roll up enhancement is to close out the initial position and replace it with a bull put spread. It all depends on a new assessment.

A bull put spread involves the sale of a put with a higher strike and the purchase of a put with a lower strike. The position produces a net credit and requires margin. However assuming the original covered write was paid in full, additional capital will not be required.

With XYZ at $29 per share, you could sell the XYZ August $32.50 put (valued at $3.75) and buy the August $27.50 put for $0.75. The per-share net credit is $2.50 with the downside risk limited to $2.50 should the stock fall back. However, you have already made $2.50 per share on your initial position so your overall risk at this point is negligible. No matter where the stock ends up!

The rub with either follow up enhancement strategy is the whipsaw effect should the underlying security fall. And that is the classic debate faced by option traders; does the underlying security continue to rally or regress to the mean?

Dealing with that debate is made more difficult if you have not given thought to exit alternatives at the outset. Decisions made in a vacuum often end badly.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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