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Educational Article

Repairing a Long Put Position

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OK, youre a directional trader. I can forgive you for that. As a matter of fact, if it werent for directional traders, we non-directional traders wouldnt have all those directional dollars so ripe for the picking. So, perhaps thanks should in order.

That being said, I realize that there will always be directional traders who roll the dice and hope for the best. I do have a bit of sympathy for those directional traders who guess wrong (most of them). So, below is one method of adjusting a directional trade that has not lived up to expectations. Check it out.

Lets take a look back at a typical put position. Normally, when someone buys a put, they believe that the underlying asset will be coming down in price. As the asset goes down, the value of the put should increase in value.

So, lets walk through a hypothetical example of putting on a put position and then adjusting/repairing it.

CELG is trading at 60. For whatever reason, the trader believes CELG has topped out and will be retracing back down.

Assume the trader purchases a $60 put for $3.00. Then, shortly after buying the put, CELG moves up to $63. The $60 put goes down in value to $1.50.

The original breakeven point was $57 ($60 - $3). Now, with CELG at $63, CELG will have to make a substantial move just to get to the breakeven point.

The trader has changed his opinion (gee, what a shock). He now believes that CELG will move down slightly, but not all the way down to the breakeven point ($57). He now will try to repair the position by raising the breakeven point. He wants to put himself into a position to possibly make $2 of profit with just a small move down from the $63 level.

He can do this by rolling up from the $60 put to create a bear put spread. Heres how it works.
1) First, he has to buy a $65 put for $3.00
2) Second, he has to sell two $60 puts, which are now valued at $1.50 a total credit of $3.00.

The new position is a five-point bear put spread long one $65 put and short one $60 put. He was able to do this for no additional cost. The trader took in $3.00 when he sold the two $60 puts and it only cost him $3.00 for the new $65 put basically a wash.

The new position ($65/$60 bear put spread) now has a new breakeven point of $62. That is $65 less the initial $3.00 it cost to buy the long put. The new breakeven point is $62, which is $5 higher than the previous breakeven point of $57. This was all accomplished at no cost.

If CELG goes back down to $60 by expiration, the new bear put spread will have a profit of $2.00. The major change with the newly created $65/$60 bear put spread is that the trader no longer has the potential of unlimited profits. By selling the $60 put, the trader has capped the profit potential at $2.00.

He was able to raise the breakeven level by five points (from $57 to $62) and still have the possibility of making a $2.00 profit. Was it worth it? Percentage wise, yes! Logically, yes!

However, directional traders are often something less than logical if, for no other reason, than that they trade directionally guessing at which way a stock will move. Why should we expect them to change personality and suddenly become logical when faced with a potential loss? Its more likely that they will take a few more puffs of that hopium drug.

Regardless, the above is one of the adjustments that can be made, and a pretty good one. Read this again and make sure you understand it. It could come in handy if you have a logic lapse and try to pick a direction.

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Hey, this is good stuff - especially if you're serious about learning options. The Pulitzer people won't likely be knocking at my door soon, but I've taught a lot of people how to conservatively and consistently make money trading options - and they're still making money to this day. I hope you'll become one of them. If you have questions, send me an email at Contact Support.

Who Is This Guy?
Mike Parnos has "been there and done that" - plenty! Mike has been writing the hugely successful Couch Potato Trader column on OptionInvestor.com for six years. Mikes been trading, consulting and teaching option strategies for over 12 years. Individually, through his writings, and at his popular two-day seminars, Mike specializes in teaching conservative non-directional option strategies while providing therapeutic guidance to thousands of individuals, brokers and institutional traders.

Over the years, he has learned from his mistakes, and the mistakes of others, and he's here to share his wisdom with you. In options trading, says Mike, what you dont know CAN hurt you.
 

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