Position selection and entry are necessary components of the trading process, yet learning how to initiate a closing (or adjustment) transaction is often the most critical requirement for achieving consistent gains. Since this essential skill is frequently lacking among new spread traders, it seems appropriate to review some of the common techniques for effectively managing combination positions. In today's narrative we"ll examine some methods that can limit losses with the call-credit (or bear-call) spread; a popular strategy for bearish markets that has enjoyed much success over the past few months. Our discussion begins with an analysis of the risk-reward outlook in a call-credit spread using common strikes and option prices in a hypothetical position.Strategy Definition
The bearish, call-credit spread involves the purchase of one call; the higher strike, and the sale of a call with a lower strike price. The combined transaction produces a credit and this amount is the maximum profit gained in the spread. The position remains profitable if the underlying security closes below the lower (short) strike price, thus allowing both options to expire out-of-the-money. Here is an example of a typical 'bear-call' spread:
Buy CALL NOV 50.00 XYZ-KJ ASK=0.20
Depending on the volatility of the underlying issue and open interest (and daily volume) in each option series, the initial 'net-credit' target would likely be $0.50-$0.55 per contract. Based on a 'fill' at $0.50, the risk/reward calculations (per contract X 100) are:
Maximum Profit = Initial Net Credit = $0.50 Per Contract
After the spread has been established with both positions open, the objective is to retain the credit generated from 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 $45, a protective mechanism must be in place to limit potential losses.
The Question: To Exit, Adjust or Cover?
The credit spread is among the most popular retail options trading strategies and one reason is there are a variety of ways to control losses or even capitalize on a reversal or transition to a new trend in the underlying issue. These methods range from simply closing the spread at a prescribed debit (or legging-out) to rolling into a long-term spread to buying offsetting options or the underlying issue to establish a 'covered' position. Clearly, the easiest tactic is to exit the short position at a debit, generally with some type of stop-limit order, and register the loss. Another common preference among experienced traders is to 'leg' out of the spread for a smaller loss or occasionally, a profit. To leg out of a call-credit spread, the trader places an order to purchase the short option when the stock moves (and preferably closes) above a technical resistance level, such as a well-established trend line or moving average, on heavy volume. After the short option is repurchased, he waits for the stock to lose momentum and sells the long position to close the entire play. It can be a difficult technique to perform when emotion enters the formula but it works well when used at known support levels or after obvious reversal signals. In the third alternative, a trader makes use of additional time for the bearish trend to resume by rolling the spread out to a future expiration date, and possibly to a higher strike price. The final technique involves covering the short option with the purchase of offsetting calls or the underlying stock as it moves through the sold strike, thereby transitioning to a neutral or bullish outlook. The latter method is great for reducing draw-downs when an issue has reversed course however there are a few complexities that must be considered when using this approach.
Regardless of which strategy is employed, the exit or adjustment trade is generally executed after a violation of a pre-determined level by the underlying instrument. The method typically used to identify the specific (stop) price is technical analysis. A thorough study of moving averages, trend-lines, recent highs/lows, etc., can help distinguish the pivot area which, when violated, would signal a probable trend reversal or change in character for the underlying issue. Another factor that should be integrated into the pre-trade analysis is the relative distance to the strike price of the sold call. Remember, option assignment will not occur if the share value is below that level at expiration. The final consideration is the potential for price volatility in the underlying issue after the spread has been initiated. A more active stock may require different exit or adjustment tactics and a larger margin for unexpected movement than an asset with relatively low (anticipated) volatility.
Buying Stock to Cover
Most exit and adjustment strategies are relatively simple in concept but techniques involving covering trades have some unique dynamics that require additional attention when choosing the trigger point. For example, the transition to a bullish covered-call must occur at a level that prevents or severely limits losses and also reduces the potential for 'whipsaw,' which can result in unwanted transactions 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 (buy/sell) stop price would quickly generate excessive commission costs thus increasing losses despite a relatively lateral trend. Since there is no way to control 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 based on the recent technical character of the issue. The strategy is simply not 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 can be very effective in cases where directional momentum is likely to continue after a primary level of overhead supply or technical resistance has been breached.
Obviously, market liquidity should also be considered along with potential transaction costs related to opening and closing new positions. The impact of slippage-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.
The transition from a call-credit spread to a covered-call will require additional funds for margin maintenance. The need for this extra collateral stems from the purchase of the underlying shares and it is generally a four- or five-fold increase. Using the generic example above, a 100-share purchase at a price of $45 would require a minimum outlay of $2250 (50% margin) initially with a possible subsequent reduction to $1125 - $1350 (25-30% margin), depending on your brokerage. Certainly, this amount is quite extreme when compared to the $450 per contract necessary to offset the maximum possible 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 call 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 sold (short) option for a reasonable loss.
Just One Alternative Among Many...
The transition to a 'covered' position offers an effective method for limiting losses with short call options when the (previously) bearish trend of the underlying issue changes unexpectedly. However, it does not guarantee an absolute resolution to the initial trade, whether a spread or uncovered option, and future adjustments may be necessary. Even when the stock's primary direction has clearly reversed to the upside, the buyer must be prepared to sell it quickly in the event of an abrupt retreat, unless he plans to own the shares for the long-term. Although the strategy is not appropriate for all types of chart patterns and price activity, it certainly deserves a place in the option player's toolbox, especially when short calls are routinely part of his portfolio.