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Position Management Basics

With the recent volatile activity in the stock market, the concept of "early exit" has become far more important for traders who participate in the limited-profit positions offered in the MCM Portfolio. In fact, most of the questions we received this month concerned the difficulty involved in correctly timing exit trades for spread positions. Considering the virtually endless number of possible situations, there can be no single, correct answer to this dilemma. However, there are methods to maximize gains and reduce losses in any trading strategy and learning to effectively manage each portfolio position is a critical skill for long-term success in the options market.

With regard to profitable trades, one of the most practical closing strategies is based on the target gain for the position. For example, if a spread is established with a projected 10% monthly return but a slightly smaller profit becomes available prior to expiration, the spread may be a candidate for early exit (based on a lower yield and shorter holding period). At the same time, most plays which meet this criterion will appear to be so successful that they "can't possibly lose" before the options expire. This pretense, along with commission considerations and the overwhelming effects of human nature - which urges a person to simply hold the play and hope for maximum profit - will prevent many traders from closing a spread early. Unfortunately, those who are prone to inaction entrust their destiny to chance because even when the underlying issue moves in the forecast direction, an option is always at risk from a variety of unexpected events or trend changes. This exposure is reduced significantly with limited risk strategies such as credit spreads, but the end result can still be very unfavorable.

Since the goal of trading is to achieve profits, a vital skill in portfolio management is determining when to exit a losing position, even as you are coping with the added mental baggage that comes with the potential for financial failure. While it seems easy enough to make crucial decisions based solely on (unemotional) technical analysis, the outcome is rarely the same when your actions are affected by the possibility of monetary loss. The truth is, we all have some difficulty making important judgments under duress and that is the primary reason for using predetermined exit points and trading stops. But, those who initiate the process early have a better chance of achieving a favorable outcome so it is important to be proactive whenever possible. As far as which method to use, the most obvious choices are: close the play for a loss, cover the short option with stock or another option, roll to a more distant (further OTM) strike and/or forward to a future expiration date, or plan to accept the obligation regarding the underlying shares (this will be a long or short stock position, depending on whether you sold puts or calls). There are other, more complex adjustment strategies but they are usually too costly or they include too much downside risk to warrant their use.


Implementing the strategies

One of our current portfolio positions provides a good platform to review some of the common exit/adjustment techniques. The underlying issue is Chiron (NASDAQ:CHIR) and it was listed on 3/3/05 as a candidate for a bullish spread. The position specifics are:

CHIR - Chiron $37.69

PLAY (speculative - bullish/credit spread):

BUY PUT APR-32.50 CIQ-PZ OI=3874 ASK=$0.30
SELL PUT APR-35.00 CIQ-PG OI=3089 BID=$0.55

INITIAL "NET-CREDIT" TARGET = $0.30-$0.40
POTENTIAL PROFIT (X 5 contracts) = $150
RETURN ON INVESTMENT (max) = 14%
COST BASIS = $34.70
LOSS-LIMIT/EXIT POINT = $35.50 (cons) - $34.70 (aggr)


Here's a current chart of the issue:



As of Friday (3/25), the stock is trading at $35.68. Adept traders will notice that our initial conservative loss-limit/exit point is only a few cents below the current price. For some readers that level may be an appropriate exit point, thus they should have a loss-limiting order in place to close the spread or (at least) the short position when the stock moves below $35.50. However, the technical condition of CHIR suggests there is moderate buying support slightly below the sold (put) strike price at $35, so we have modified the target exit point to $34.50. Traders who favor a more aggressive stance in the position might be comfortable with our decision to lower the stop, but there remains the matter of identifying a suitable exit (or adjustment) strategy.


The "easy" way out

If you prefer to simply close the position, you can place a contingent order to exit both sides of the spread at a specified "net debit" or when the stock reaches a certain price. Another alternative is to close the short option and retain the long option in anticipation of the underlying issue moving lower. This technique is often described as "legging" out of a spread and it is most effective when the stock trades, and preferably closes, below technical support or a well-established trend line or moving average on robust volume. There are certainly more precise (technical) signals available to initiate this procedure however the strategy is based on the probability that, once a reversal has occurred, the stock should continue to move in that direction. Eventually, the bearish activity begins to lose momentum and the long option is sold to close the entire play. Obviously, other factors affecting the price of the option may need to be considered such as implied volatility, distance from strike, and the time remaining to expiration.


An optimistic outlook

The most common "adjustment" strategy for a bullish credit spread is a roll-out (forward and/or down) to a new position. This technique involves repurchasing the short options and selling the long options, either individually or through a "net" order. Then a new spread is initiated with both longer-term and generally, lower strike options. The objective, as with the original position, is for the sold options to expire worthless. If possible, it is best to transition to the closest available month, so that you can sell the highest relative premium and not commit your portfolio capital for an extended period. Traders who do not want to "lock-in" a loss from the original position should roll-out as far as necessary to achieve a credit in the trade.

In the case of CHIR, there is no advantage in rolling to May options however a viable credit exists in the JUL-30/32.5 put spread and that position should provide a favorable cost basis for traders who believe the issue will recover in the future. Because we foresee an eventual
rebound in CHIR's share value, this is our current recommendation (in the event of further downside activity) for readers in the MCM Portfolio position.


A "range-bound" solution

If the stock drifts lower and the primary trend changes to a lateral consolidation, a trader could transition to a neutral-outlook calendar (time) spread. As you may recall from the recent strategy narrative, a calendar spread (also known as a horizontal spread) involves the purchase of an option with one expiration date and the sale of another option with the same strike price but a different expiration date. Time erodes the value of the short term option at a faster rate than the long term option so if the price of the issue remains relatively unchanged until the near-term option expires, the spread will achieve a profit.

With the stock price in the $33-$35 range, the JUL-$35 put would likely be the most appropriate option to buy. The MAY-$35 put simply does not have enough time value to make the strategy effective and although the cost of a more distant expiration is slightly higher, the debit can eventually be reduced with the sale of near-term options. Once the transition has been made, a trader should monitor the technical character of the underlying issue for any significant changes. If CHIR moves in a small range and ends the expiration period near the sold strike, he could simply sell the JUL-$35 puts to close the position. If the outlook remains relatively neutral and the option premiums are still robust, he might sell the MAY-$35 puts to reduce the cost basis in the longer-term position, hoping to earn a greater profit when the JUL-$35 puts are eventually sold. Obviously, there are endless variables in the position management that follows the initial trade but they are all based on a common techniques and fundamental components of option pricing.


Owning the stock

Finally, if you allow the assignment of a short (put) option because future upside potential is expected, you can write covered-calls to regain lost capital in the position.
The concept is to produce cash flow by selling call options against shares of the underlying issue, which are held in your portfolio. This widely-used strategy is relatively easy to master and the resultant (combination) position is generally more conservative than outright stock ownership. In addition, the sale of covered-calls can be a profitable with most stocks as long as the outlook (fundamental and/or technical) for the issue is favorable. There are other, more subtle benefits and disadvantages but these are the most common reasons that investors choose (or avoid) this technique.


Small losses = big profits

The success of a limited-profit strategy such as selling credit spreads is based (in the long run) on minimizing losses. Indeed, that is why it is essential to utilize the suggested loss-limit/exit points we include with each new candidate. Most people simply can't monitor the market on a constant basis, so there is little chance they will be able to identify (in a timely manner) the circumstances that require a potential exit or adjustment. Obviously, the MCM staff must (and will) make some major improvements in the way we convey specific position management tactics to each subscriber and we are (now) definitely aware of the need to offer explicit instructions for each trade. In addition, we will continue to discuss a variety of techniques to help less experienced readers learn how professionals deal with unexpected activity in their portfolios. Our ultimate goal is to make this product useful to all of our readers, regardless of their level of knowledge or trading experience. Please bear with us as we transform this objective into reality.

Trade Wisely!





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