Q&A
Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the Stocks & Commodities website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C. Contributing analysis is by senior Optionetics strategist Chris Tyler.
BUY MORE FOR LESS?
I recently bought calls that proceeded to go up in price despite implied volatility dropping fairly hard from the levels associated with my initial purchase. Not wanting to look a gift horse in the mouth, yet wanting to maintain some directional exposure but also unwilling to sell call premium that appeared too cheap to me, I sold two-thirds of my position and let the balance ride. Do you think this was the right adjustment to make?
Congrats on taking one course of action that, as the saying goes, allows you to have your cake and eat it too. As a rule, you can’t fault your adjustment if, when executed, you took what you considered to be an acceptable portion of your profits and were confident with the size of the remaining position whose premium remains vulnerable to opportunity costs.
In what is typical of this type of scaling out of a position, many traders will look to adjust and sell half of the contracts once a profit of 50% to 100% is reached. For instance, if you purchase 10 calls for $1.00 and can sell five for $1.50, the balance of the five contracts still held have an effective price of $0.50, while selling five for a 100% gain or $2.00 would allow for a free call position on the remaining contracts. That said, it looks as if your actions were motivated by this popular adjustment route.
Another adjustment based on your objective to remain net long deltas would have been to look at a ratio backspread or even a ratio calendar backspread as an alternative hedge. The ratio backspread sells fewer contracts, typically in- or at-the-money, and buys a larger quantity of at- or out-of-the-money options. Since the backspread position is buying net long contracts, the position is more attractive when premiums or implieds are cheap, which was the situation you were faced with.
In buying the backspread but closing to sell a profitable in- or at-the-money call while purchasing the higher strike call, you’re taking in a credit to gain more contracts. How that credit stacks up against the initial debit is your net dollar exposure for the larger call position now held. Often enough, when implieds are affordable, you can keep the same current delta (directional) exposure before adjustment but have a good deal more deltas above the strike for even larger profits than with the original call position.
For the backspread adjustment to work as intended, you’ll need favorable movement from shares. Having some time still on the clock before expiration also improves your chances of seeing this strategy outperform. Remember, at the time of the adjustment the calls are built entirely of extrinsic premium, which in the final 30 days become increasingly subject to the vagaries of time decay.
Due to the contracts’ premium risk, what you see may not be what you get. In fact, at expiration, you could wind up with the adjusted debit as your loss compared to a profitable, whittled-down contract that’s gone further in-the-money over time. A simple illustration of this would be if you purchased +2 at-the-money March 25 calls for $1.00. A few sessions later and fewer than four weeks until expiration, shares have rallied to $26.10 and boosted the call to $1.60. At the same time, the out-of-the money March 27 call is trading for $0.55 per contract.
In the first scenario, using a scaled sale program of adjustment, the trader sells (to close) one contract or half the position, leaving them long +1 in-the-money March 25 call for a below-market debit of $0.40. Using a ratio backspread, the trader could sell both 25s for $1.60 while purchasing four of the 27s for $0.55. This yields a credit of $100 total. In turn, the net dollar risk has gone from $200 for the +2 March 25 calls to $100 and owning +4 March 27 calls.
For the trader wishing to remain long deltas, there is the backspread’s net delta, which should be much larger than the adjusted, standalone long March 25 call. Even better, above $27, the trader is net long 300 more shares of stock (deltas) using this strategy. Gains could quickly dwarf those of the sell half & hold method if the stock ran aggressively through the 27 strike.
And let’s not forget, with the backspread call position also situated out-of-the-money and the clock ticking down toward expiration, in order to maintain or pick up deltas, the underlying stock will need to move more favorably than with the former strategy.
For instance, if shares wind up rallying more slowly over the next few weeks from $26.10 to $27 at expiration and squarely at the rolled-up strike, the backspread’s +4 calls will be facing a loss of the full adjusted debit of $100 or $0.25 per contract. On the other hand, holding one adjusted March 25 call for $0.40 would produce a profit of $1.60 or $160 in total with a parity to-close sale of $2.00. Yet if shares were to rally to $28, the call would yield a $2.60 or $260 profit versus $0.75 on four contracts or $300 for a long call, backspread adjustment.
If the trader were to receive slightly more favor from the trading powers-that-be and find shares at $29, a profit of $360 versus $1.75 x 4 = $700 would be the lopsided profit comparison—and that would be one that’s easy to appreciate why, when, and where the backspread might be a smart option for adjusting.