Option Investor

Strategy Review

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Position Management Basics

As almost every trader knows, the key to success in the options market is position management. Regardless of how well you forecast the trend or character of a specific issue, you can still lose money if you don't learn to take profits and limit losses in a timely manner. However, that ability is one of the most difficult skills to master when dealing with limited-risk strategies because there is relatively little margin for error.

Due to the unique characteristics of derivatives, there are a number of techniques used to close, cover and adjust common positions. But, there is more to position management than simply making a specific type of exit trade - timing is critical as well. Although spreads and combination plays are generally designed to reduce risk, they also offer lower potential profits. This attribute suggests that a specific exit point is even more essential for those occasions when the underlying issue moves in the opposite direction from that which is expected.

Learning when and how to initiate a closing transaction is an integral part of being a profitable trader. Since this topic is the focal point of many of the questions I receive concerning credit spreads, it seems appropriate to review some of the best techniques for managing the short options in combination positions. In today's narrative, we will examine the strategy of "covering" a sold call with the purchase of stock. To begin our discussion, let's review the risk-reward outlook in a credit spread using a recent portfolio position.

Strategy Specifics: "Bearish" Call Credit Spread

The bear-call spread involves the purchase of one call (higher strike) and the sale of a lower strike price call. This spread produces a credit and the amount is the maximum profit gained in the play. The spread remains profitable if the underlying security closes below the lower strike price and the objective is for both options to expire worthless.

Amazon.com (NASDAQ:AMZN) was offered as a "bear-call" candidate on February 6, 2005. The position data is as follows:

BUY CALL MAR-42.50 ZQN-CV OI=2847 ASK=$0.20

SELL CALL MAR-40.00 ZQN-CH OI=1626 BID=$0.45

The initial "net-credit" target is $0.30-$0.35 and based on a "fill" at $0.30, the risk/reward calculations (per contract X 100) are:

Maximum profit = the net credit received = $0.30

Maximum risk = difference between strike prices - net credit = $2.20

Cost basis = sold (call) strike price + net credit = $40.30

Return on Investment = net credit / maximum risk = 14%

A Simple "Covering" Technique

After the spread has been established with both positions open, the objective is to retain the credit generated through the sale of the short calls. Hopefully, this will occur through option expiration but if the underlying stock trades near the sold (call) strike price at $40, a protective mechanism must be in place to limit potential losses. One of the simplest adjustment techniques is to purchase 100 shares of AMZN stock to "cover" each short (call) option when it moves in-the-money.

By contract, a trader who writes calls has a requirement to provide shares of the underlying if the option is exercised, thus a two-fold objective can be achieved through the use of a buy-stop order on the stock. The short option in the spread is protected against upside activity and a long position in the issue is assured. Keep in mind, you must use a STOP, not a LIMIT order, as the latter does not guarantee a trade will occur. For those readers who are unaware of the differences, a stop order is defined as:

An order to buy or sell option contracts when the market for a particular contract reaches a specified price, called the stop price. A stop order to "buy" becomes a market order when the option contract trades or is bid at or above the stop price. A stop order to "sell" becomes a market order when the contract trades or is offered at or below the stop price.

In simpler terms, if you use a stop order and the underlying issue trades at or above your buy-stop price, the order will become a market order. This is not the case with a stop-limit order. If you use a stop-limit order and the issue moves too quickly to trade at the limit price, the order will not be executed.

Implementing the Strategy

With this type of loss-limiting system, the "covering" order is executed after a violation of a pre-determined level. The method commonly used to determine the specific stop price is technical analysis. A thorough study of moving averages, trend-lines, recent highs/lows, etc., can help identify the pivot area which, when violated, would likely signal a trend reversal or change in character for the underlying issue. Another factor that should be included in the process is the strike price of the sold (call) option, because assignment will not occur if the share value is below that level at expiration. The final consideration is the potential for volatility in the underlying issue after the order has been executed.

With these dynamics in mind, it becomes obvious that choosing the stop price is the most difficult part of this strategy. The transition to a bullish (covered-call) play must occur at a point which prevents, or significantly limits, losses and also reduces the potential for "whipsaw," which can result in unwanted trades as the long stock position is established, then closed, then reestablished, and so on until the option expires. As you can imagine, a volatile issue moving back and forth across the stop price would quickly generate excessive commission costs and the slippage inherent in each transaction could increase losses as well.

Since there is no way to alter the movement of the underlying stock, the key to success (or achieving the maximum amount of success under the circumstances) is discerning use of the covering technique. The strategy will not be appropriate in many situations, especially those where the chart pattern suggests a high probability of range-bound activity near the sold strike price. In contrast, it is most effective in cases where directional momentum is likely to continue after a primary level of overhead supply or technical resistance has been breached.

Market liquidity should also be considered along with the cost of slippage from opening and closing new positions. The impact of transaction-related losses can be amplified by a number of factors including large bid/ask spreads, incorrect or inaccurate pricing and delayed execution of trades. Fortunately, careful position selection can eliminate liquidity concerns, while data and execution issues can be largely overcome through the use of a broker or trading platform that provides accurate quotes and consistently responds to orders in a timely manner.

Collateral Requirements

As you might expect, the transition from a call-credit spread to a covered-call position will require additional funds for margin maintenance. The need for extra collateral stems from the purchase of the underlying shares and it is generally a four- or five-fold increase. Using the AMZN play above, a 100-share position at a price of $40 would require a minimum outlay of $2000 (50% margin) initially with a possible subsequent reduction to $1000 (25% margin), depending on your brokerage.

Obviously, this amount is quite extreme when compared to the $220 per contract necessary to offset the maximum potential loss in the spread. At the same time, the high cost of implementing the strategy has a comparable reward in that it is far more effective at preventing draw-downs with active stocks than a "buy-to-close" order on the short option. The reason for this (favorable) disparity stems from the mechanics of derivatives pricing. An option on a volatile issue will almost always command a premium when the underlying is near the strike price and moving "in-the-money." Of course, this is exactly the same time the trader is trying to close the short option for a reasonable loss.

In summary, the "covering" technique offers a timely and effective method for limiting losses with short options when the underlying issue threatens to rise above the sold strike price. However, it does not guarantee a final and absolute outcome to the initial (short) position because future adjustments may be necessary. Even when the stock's trend has clearly reversed in the near-term - forcing the covering strategy to be implemented - a trader must be prepared to sell the shares in the event of a future retreat (unless he intends to own the stock for the long-term). Indeed, the potential draw-downs from additional transactions confirm the strategy is not a panacea for every losing play, but it certainly deserves a place in the astute option seller's toolbox.

Trade Wisely!

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