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Apr 16 2010: Every investor will always face the
question of whether to close the trade and
secure their final profit and then reconsider
new entry points or an entirely new stock, or
whether to continue the trade. How does an
investor decide? It is actually easier than you
think:
Here is what I do:
A) Decide whether or not the stock is still
going to perform properly for my trade to work.
B) Decide if the return from the short calls,
which I can make by staying in the spread and
rolling the short side further out, is
worthwhile. This is an individual choice but
normally I like to be able to make almost as
much as the original trade when I started the
spread. Therefore the return has to almost be
double. There is nothing wrong with doing the
trade for a smaller premium, but normally if I
cannot double my profit, close the trade and
take my profit now. Then I assess setting up
another trade with the same stock or moving to
another stock entirely.
C) Decide on my comfort level.
To figure out A,B and C I do these steps:
A) Decide whether or not the stock is still
going to perform properly for my trade to work.
I look at the past 6 months of the stock. Has
there been any pullback and once the stock
pulled back did the trend higher continue? If
the stock has done nothing but move higher than
I would be concerned of a pullback. When I look
at the VISA chart above I can see there have
been pullbacks all along the way. Every pullback
was tested and held and the stock moved higher.
I look upon this as excellent signs that
accumulation of the stock continues on every
decline. If there were no buyers then the stock
would pullback and fall steeply until it reached
a critical support level. Meanwhile in my chart
above I can see that the stock pulled back,
stopped, was accumulated by investors and pushed
higher. This tells me there are still plenty of
buyers.
B) Deciding whether to close the trade or roll
to the next month.
This is the easiest part.
If I close the trade now with April expiry I
will earn:
$1050.00 from the spread itself
$2449.25 from selling the April 90 calls for
$3.65
($325.75) deduct the April $80 protective puts.
=
My total return would be $3173.50 or 10.9%.
Therefore, if I close now, I will have earned
10.9% in one month on my bull call spread.
Step 2: Do I want to roll into May and
continue the Bull Call Spread?
To Buy Back the April 90 calls I am going to
spend $3.65 X 15 contracts for a total cost of
$5500.75 including commission.
To Sell the May 90 calls I will receive $5.35 X
15 contracts for a total income of $7999.25
including commission. The income on this roll is
$2498.50. (7999.25 less 5500.75)
It is easy to see that the bull call spread
should be continued. I earned $2449.25 from
selling the April 90 calls while selling the May
90 calls earned me $2498.50 or almost the same
amount. The return will be double my April
return.
If the spread works out by May expiry, with the
stock at or above the May $90 strike, my return
is:
$1050.00 from the spread itself
$2449.25 from selling the April $90 calls
$2498.50 from selling the May $90 calls
(325.75) deducted the April $80 protective puts
=
$5672.00 divided by the original purchase of the
Jun $70 calls of $28,975.75 = 19.57%. or just
about double the April trade.
Addendum: I would move to June and sell the
June 90 calls which were trading at $6.00 as
while they are higher in premium, they are not
double the premium of the May calls so my return
is lower when spread out over the 2 month
period. (May and June).
C) Decide on my comfort level: I
looked at the chart and I am happy with the
stock action. My return is double by staying for
another month and my capital at risk has been
reduced by an additional $2498.50 to $24,028.00
on 15 contracts. If I wanted I could purchase a
few protective puts to try to hedge the trade.
Closing: A few readers asked if I would
consider the May or June $95 strike. I would not
consider this, but for those who are risk
oriented, I would suggest the Jun $95 at $3.20.
However this means I would be rolling for a
net debit as the April $90 is costing $3.65
to close and this is not something I would do. I
therefore would stay with the $90 strike and
roll for a net credit. If I roll to the
$95 strike, I have effectively placed my trade
in jeopardy as I have given up income in order
to try to gain from the stock moving to or above
$95.00. If I thought the $95.00 strike would be
a good choice, I would close my original trade,
take my profit and then set up a new trade.
QUESTION FROM A READER: Hello. I had a look
at the diagonal bull call spread on Visa and
wonder why you choose the long call so far ITM.
It appears that this would be a stock
replacement technique and the Jun 70 call with a
delta of .91 is a good candidate to sell covered
calls against. However the IV is quite high
since the strike is so far away from the
underlying and when looking at the 80 strike
instead I couldn't find a good reason not to use
it instead.
It appears to me the
Jun70c is overpriced as indicated by the IV.
Current figures on your 15 contracts
+Jun70c/-Apr90c spread show the following data:
cost $17.59...
current prc $88.80... Jun70c IV
35%... Apr90c IV 22%...
Risk amount $26,385... Delta 730... Theta 38...
Vega -47
By doubling the
number of contracts to 30 and using the
Jun80call you get the same amount at risk and it
seems to me the greeks are much better. Although
the Jun80c has a delta of .79 compared to the
.91 of the Jun70c the spread delta for the same
risk is greater.
30 contracts +Jun80c/-Apr90c:
cost $8.61... current
prc $88.80... Jun80c IV 27.5%...
Apr90c IV 22%... Risk
amount $25,830... Delta 1109 Theta 56... Vega 88
A
one point increase in the underlying will
already achieve $1100 profit compared to $730
using the Jun70c. Also the Theta nets $18 a day
more. I think the Vega is advantageous too since
if the stock declines the positive Vega will
mitigate the decline somewhat and compensate for
the higher delta whereas the Jun70c negative
Vega would lose $47 for each 1% increase in
Vol.
Please let me know if I am missing something
here, and thanks for your great website and help
in showing others your planning and thinking
process.
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MY ANSWER: It is a question of time and
position.
You are right that the Jun $80 for the Bull
Call Spread makes a good entry. As well I also
considered the $75. The probability indicators
show the chance of the stock falling to $80 is
around 4.5% (very low). The chance of $70 is
.00063% The chance of $85 is at 23%.
However in my strategies I cannot just rely on
the Greeks, probability indicators or my
10-20-30 rules or candlesticks. My strategy also
has to contain protection, be as conservative as
possible given the desire to place a spread
trade and draws upon my years of being in the
market place. I want to increase the odds for a
favorable outcome. I have held spreads through
some particularly troubling markets. Just when I
thought things were perfect, the market would
hand me a surprise.
I
choose the $70 strike to guard against a serious
or unforeseen market downturn. (think 9/11) I
have left myself plenty of room and therefore
more time to make further decisions and rescue
as much as possible my trade. Holding the $80 is
10% below the present valuation and certainly an
excellent long point, but there is only one
strike above it to sell in the event of a
serious downturn. I remember holding stocks
through some wild one day or weekly events and I
can recall what saved me. It was time and
position.
I
was holding many bull call spreads on Oct 20
1987 when the market fell more than 20%. The
market bounced up the next day and then
commenced falling and by Oct 29th we were down
more than the 20% one day drop and by Nov 11 we
were lower than Oct 29th.
On
July 22 1998, most of my stocks were holding
their own. 12 trading days later I was down 20%.
The market had a short 8% 6 day rally and then I
was down 23% in 9 days. The window of
opportunity to reposition trades is often very
small. Oct 20 1987 had only a one day window to
reposition the trade. Put values went through
the roof and I lost as much as 30% on some
spreads over a period of 5 days. On Sept 17 2001
when the markets reopened after 9/11, the Dow
fell 7.1% in one day and by week's end the Dow
was down 14.3%. It was the worst week on record
until the 2008 credit crisis.
Aside from these events let's look at Visa
itself:
On
Friday Jan 9 2009 Visa was trading between 55
and 56. On Monday Jan 12 it fell to 52.96 and by
the next Monday it was at 42.00 a fall of a
little over 23% in 6 trading days.
Jun
9 2009 - Visa hit a high of 70.37 and 7 trading
days later the stock hit a low of 60.63 a drop
of 13.8%
Sep
23 2009 - Visa hit a high of 74.99 and 7 trading
days later the stock was down 7.2% at 67.79.
Jan
20 2010 Visa traded as high as 87.74. 6 trading
days later Visa had hit a low of 80.99 and
closed at 81.15 a pullback of 7.6%.
On
March 12th 2010 Visa closed at the high: $93.58
and my 10-20-30 technical indicators showed a
stock in full uptrend. Also the stock closed at
the high making a bullish candle. Now 5 trading
days later we are at 88.84, a drop of 5%.
Let's look at my strategy:
If I
look at the past pullbacks over the last 12
months I see that the worst pullbacks are in
earlier 2009 and that the last 2 pullbacks were
contained around 7%. I feel this present drop of
5% is coming to an end and placed my bet on the
bull call spread. I could easily be wrong and I
added 15 April 80 puts at .20 cents during
trading on Friday to cap my losses at the $80
strike.
The
problem for me with the $80 strike is the
"wiggle room". At $80.00 all my capital is at
risk in any 10% move lower. I can't really
protect that capital with an 80 put. At the $70
level, I feel I have more time to adjust, close,
roll, add more puts, whatever. These are all the
same things I could do when holding the $80 long
call, but at $70, I feel I have a little more
"wiggle" room to study and not react with
emotion. Also being at 70.00 I can continue to
sell calls at $85.00, then $80.00 and then
$75.00 if need be. I have done this strategy
numerous times including during Sept 2008 and in
Feb 2009 when the market began to fall apart. I
was able to rescue my call spreads and actually
turn a profit on many of them simply because I
was so deep in the money with my long call side.
It also afforded me lots of opportunity to roll
out and continue the trade in the following
month(s). Premium levels normally increase if
there is a strong pullback and this helps my
strategy. As previously mentioned, at the $80
long call strike, I only have one strike above
$80, which I can sell.
In
the past when I was holding what I thought was a
beautiful trade only to find out that a month
can be a long time, I found that I tended to
react faster, watching my trade fall apart.
Today, through experience and by placing my long
side deeper, I can revaluate and decide on a
course of action, without any emotion. Time is
on my side.
One
final observation: You mentioned doubling up at
the $80 strike, to place at risk the same
amount, but increase the profit potential. I
would not do this at $80 strike, for the reasons
just mentioned, but would only hold 15 contracts
and place at risk half the amount. I think it
will be easy to adjust this position with 15
contracts should the stock fall. |
