Option Investor

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No Joy In Mudville!

It was another "swing and a miss" for the stock market Wednesday as the major equity averages retreated sharply on inflation concerns and trade deficit woes. Blue-chips were battered by a weak outlook from General Motors (NYSE:GM) and the broader sectors were hampered by the rising price of crude. Even the 17% jump in Research In Motion (NASDAQ:RIMM) failed to inspire investors as all roads seemed to point down in the wake of the market's recent climb to 3-year highs.

Our portfolio was no different than most with the majority of issues trending lower as the session progressed. While many of the positions have large downside margins, a few of the recent picks are performing worse than expected and it is worthy to review our plans for these plays in the event of additional selling pressure. One of the most obvious surprises is Vimple Communications (NYSE:VIP) and it's amazing that we fought so hard on Monday to enter a spread that is now approaching a potential exit or adjustment. There is no news to explain the sharp decline, however some traders believe it may be related to losses in the Russian financial markets. Regardless of the reason, the issue is dangerously close to a recent support level and if this area is breached, there is little hope for a rebound in the short-term. The first test of buying pressure should come as the stock nears $35, and if that fails, a second level near $34 will probably do little more than slow the decline. In addition, there is the possibility of a mediocre earnings report (no date published yet) and the market is generally a cruel judge when the broader trend is bearish.

With this fact in mind, we are going to recommend that conservative traders exit the short position in the spread on any sustained move below $35. If this activity occurs, the (put) option premiums should remain robust in the near-term, thus providing a reasonable closing price for the long option and a smaller overall loss in the position. This strategy is known as "legging" out of a spread and without going into great detail, the objective is simply to utilize the movement of the underlying stock to your advantage, buying the short option when it is cheaper (or absolutely necessary) and selling the long option when it is more expensive. Obviously, each individual trader will have to use some personal judgment in determining the exit point for each position as there are no "hard and fast" rules with technical analysis (and that's the primary means on which to base the decision). Of course, this tactic becomes easier when you are familiar with the stock, its sector, and the overall market trends, and it is more productive for those who learn basic chart patterns and you use the appropriate tools to analyze each issue.

If risk versus reward is the principal concern, the exit point should be established with regard to the probability of achieving the expected profit and the potential for additional loss. While this approach sounds complex, one means to an end is very simple. You can determine a threshold; a price at which you can accept no additional losses. Some spread traders are comfortable risking 4 or 5 times the expected profit throughout the life of the position. Others can not tolerate an option that is even "near-the-money," no matter how great the chance of a profitable outcome. A common rule of thumb is to use a "buy-to-close" stop order at a price that is no more than twice the original credit received from the sold option. A more aggressive approach would be to close the short position when the underlying share value moves below the strike price. Regardless of the method you favor, understand that learning to correctly manage losing positions is one of the most important aspects of profitable trading. In fact, the key to success with a limited-profit strategy such as credit spreads is really the position management that follows the initial trade. In all cases, consider the adage, "Traders become successful when they learn to take small profits regularly and they don't let losing plays significantly erode capital."

Trade Wisely!

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