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Mark Wolfinger helps a spread trader think through a mid-trade decision


I'm sure you've been there: you've put on a given trade, with half an idea of how that trade might play out. Chances are you've paid more attention to the rosiest, most profitable scenario and not visualized all the other possible scenarios as clearly. Take scotphil's recent example of an AAPL spread:  


So a few days ago I collected 0.29 per contract on a AAPL 365-370 July 15 expiration call spread. I sold 5 contracts thus collected roughly 150 bucks....though a small reward I felt really comfortable that even if AAPL rose (which it has) the stock would fall short of surpassing 365 by expiration, thus allowing me to pocket the 150.  

So as I sit here Friday afternoon AAPL is at 358...trading up in a down market.....I could close the option right now and pay $300 or I could let things play out next week....there is definitely some technical resistance as it tries to get into the 360s...especially around 365......

Just wanted some feedback from option traders as to what you would do....my gut is telling me to stay in the trade.


Before you read any further, you'll need to recognize what a spread is. In this example we're discussing a short call spread, consisting of the following:


Sell 5 AAPL July 365 calls

Buy 5 AAPL July 370 calls

Net credit collected of $0.29

TradeKing's commission: $4.95 + ($0.15x10) = $6.45 to enter the spread


If you hit this trade's max profit potential, as scotphil indicates, you get to keep the entire net credit - which is not very big in this example. That happens only if AAPL finishes below $365. You could incur the trade's max potential loss if AAPL moves higher than $370. (Specifically, the trade's max loss is the difference between the two strikes, 5, minus the credit of $0.29 - that's $4.71 on the table.)


SP,

 

Over the long term, you will not do well by trusting your gut – unless your gut has a proven track record of being correct. Most of the time our gut tells us just what we want to hear, and right now you want to hear that AAPL is not moving much higher.

 

I have no opinion on this stock, but want to provide the trade feedback that you requested. Here are a few thoughts:

 

All trades should be accompanied by a trade plan. The most important part of that plan is to have a profit target (and it does not have to be to allow the options to expire worthless) and a maximum loss target. You obviously do not have that plan, or you would have exited this trade before now.

 

I like trading credit spreads. When risk is managed with care, this can be a very profitable strategy. That said, selling 5-point spreads for peanuts is a losing proposition over the long term. Sure, you get a good probability of success – and that’s what makes it so tempting. But it doesn’t take very many "unlikely events" to occur to bust the bank. Do you truly believe it is reasonable to risk $471 (plus trading expenses) to earn $29? Let me assure you that it is not a good idea.

 

Trading short-term option spreads is far riskier than trading longer-term (I am not suggesting 6-month spreads or LEAPS, but am suggesting two- or three-month spreads). Why? Because negative gamma is far more explosive for short-term options. True, you get much more rapid time decay with short-term options, but my suggestion is to pay more careful attention to risk (and that’s gamma), rather than to reward potential (that’s theta).

(Gamma is the Greek that measures the theoretical impact of changes in the stock price on the option's delta; delta, in turn, measures the theoretical impact of changes in the stock's price on the option's price. Theta is the Greek that tracks time decay, or the theoretical impact of one day passing on an option price. If you don't know what any of these terms mean, check out Meet the Greeks to acquaint yourself.)

 

The bottom line for traders is that those who fail to exercise proper risk management are almost certainly doomed to failure.

 

What to do now? I have no idea. But if you had a trade plan in place, the decision would have already been made.

 

   

Regards,

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.

 

Online trading has inherent risk due to system response and access times that may vary due to market conditions, system performance, and other factors. An investor should understand these and additional risks before trading.


Mark Wolfinger does not hold any positions in the securities mentioned in this post.

 

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Gamma represents the consensus of the marketplace as to the theoretical rate of change of Delta relative to the underlying security;delta represents the consensus of the marketplace as to the theoretical price movement of the option relative to the underlying security;theta represents the consensus of the marketplace as to the amount a theoretical option's price will change for a corresponding one-unit (day) change in the days to expiration of the option contract. However, there is no guarantee that any of these forecasts will be correct.

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