Option Investor

Strategy Review - Position Management

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Trading Basics - Closing a Position

With our recent unexpected activity in Infospace, now is an appropriate time to discuss exit strategies.

To that end, we will start with the "early-exit" data offered with each new position. Our current approach includes a stop-loss point, based on technical analysis, and a suggested spread-closing debit, based on percentage loss. The first technique involves a contingent order to close the sold options in the spread when the underlying stock trades at or beyond a particular price. A thorough explanation (and screen shot) of this type of order is located here:


Readers who used that method with INSP were out of the MAY-$40 puts a few minutes after the opening bell for Wednesday's session. That left the remaining long options available to be sold at a later time, thus substantially reducing the loss in the spread. As you can see, it's a good method for issues that reverse course unexpectedly because you can often use the new trend to your advantage when closing the long options in the position.

In contrast, traders who want to limit draw-downs based on a percentage change in the value of the spread often utilize a net-debit (limit) order to close both option positions simultaneously. With this approach, the target (exit) price is generally a multiple of the initial credit in the spread and we recommend a limit of roughly twice the per-contract profit for a conservative position. For readers who use the OptionsXpress platform, the Stop on Spread order is available as an advanced trade. Here is a screen shot for the Stop on Spread (market) order with the INSP position:

Since this is a complex order, the screen shot reflects only one of the possible variations and it is not yet available (for a more in-depth example) in the virtual portfolio - only with "real" positions. However, a detailed (textual) description follows:

To place the Stop on Spread order (from the positions page), click on "Sprd" under the Action column. Then on the order form, choose "Stop Order" from the advanced drop-down box. Then click preview, and on the next page you will be able to enter the stop price you want the (exit) trade triggered at, and if you want it to close at "market" when that occurs, simply leave the default settings on the order form. If you want a specific "limit" debit price to be triggered by the order, you can do that as well. Keep in mind, there is a possibility the stop could be hit, even thought the limit has not been met, so you wouldn't be out of the position until the limit is reached after the stop has triggered. The unique facet of this order is that it is processed "in house" by OptionsXpress' complex software-based technology, so the trade is initiated only when the difference in the individual option prices reaches the target threshold.

One reader noted that some brokerages do not accept this type of order and if that is the case, you can substitute a One Triggers Other (OTO) order, which generates a second order contingent upon the fill of the first order. The only difference in this approach is the "stop" price used to close the short options and without getting into detail - definitely a subject for another narrative - a general rule of thumb (for OTM credit spreads) would be 2 to 3 times the initial sale price of the option.

Here is a screen shot (using the OX platform) of the OTO trade set-up:

and the second page, which defines the "triggered" order:

Obviously, some of the MCM positions are going to be "losers" regardless of the exit strategy used by traders who follow the portfolio. However, it is important to be aware of the various techniques for closing/adjusting spreads because there are definite advantages to specific strategies, based on the projected trend or character of the underlying issue. As one of our more astute readers demonstrated Wednesday, the drawdown in the INSP spread could have been significantly reduced simply through the use of the (recommended) contingent stop-loss order on the sold option. Although it did not provide a "timely" exit, the closing trade for the MAY-$40 puts established the maximum loss for the short position, allowing the long options to be sold later in the day for a sizable gain. While this isn't the outcome we would expect in every situation, it demonstrates that even the worst "catastrophe" can often be improved by traders who choose to be proactive in their position management.

Another Hatchet Falls...

Shares of Estee Lauder (NYSE:EL) tumbled Thursday after the cosmetics company missed consensus earnings estimates by a wide margin and offered a cautious outlook for the coming year. The price of EL, whose brands include Clinique skin care and Aramis fragrances, fell nearly 8% to a new 52-week low during the session and based on that activity, it appears the long options in our (adjusted) calendar spread will have little value in the coming weeks. The only hope for our neutral-outlook position is that the stock rebounds in the future. However, we now have long options in place to establish another "bear-call" credit spread at $40, and the technical indications suggest this may be a favorable way to recoup some of the losses in this position. A credit of $0.25 - $0.35 seems viable for the MAY-$40 calls, and that would reduce the cost of the JUL-$45 options to roughly $0.80 per contract. If the short position expires in three weeks, we can reevaluate the technical condition of the underlying issue and pursue further adjustments at that time.

MCM Staff

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