You did your homework. You drew trendlines, added moving averages and watched formations and oscillators. You practiced patience. Your favored stock finally hit the support you'd identified and bounced. You bought calls.
For a week, your play works spectacularly. The stock gaps almost four points higher and holds that level. You're a position trader and you check the value of the stock and your calls each afternoon just before the close. You consider taking profits since your calls have more than doubled, but it's doing so well and you vacillate.
Then late one Wednesday--not even a merger-and-acquisition Monday--you turn to your computer screen to find that your favored company will be acquiring another company. Investors didn't like the idea. The stock had gapped lower. The calls that had been bid at $5.25 the previous day, and for which you'd paid $2.41, dropped to a bid of $2.05.
First you lament your poor account management skills. You should have locked in that profit. Then you consider your three choices: averaging down, selling and taking the loss, or staying in and hoping for the best.
That's what happened to call buyers in Cimarex Energy (XEC), with the company deciding in January to acquire Magnum Hunter Resources. For most of a year, Cimarex had been bouncing from its 100-ema. Often CCI moves up through the zero line accompanied those bounces, corroborating them.
Traders in that situation might have had more than three choices, however. Note that XEC dropped only to the 100-ema, an average from which it usually bounced. If a long call owner believed that XEC might still bounce after a period of consolidation, other choices existed. It was time to pull out that copy of McMillan's OPTIONS AS A STRATEGIC INVESTMENT from the dusty bookshelf. McMillan discusses two other defensive strategies a call owner might employ to repair a losing position.
Before examining other strategies, it might be helpful to benchmark the loss that would have been incurred if the call had been sold and no further tactics explored. Assume a purchase of a March 35 call on January 12. No March 35 volume occurred that day, but the CBOE option calculator returns an estimated price of $2.41 per contract. For the purposes of this article, commissions will not be considered. Prices discussed here will be prices per contract, with the understanding that actual position costs must be multiplied by 100 to obtain the true cost. With those assumptions, the drop from the estimated January 12 cost of $2.41 for the March 35 call to the January 26 closing bid at $2.05 resulted in a $0.36 or 15 percent loss.
Estimated Cost of a March 35 call contract purchased on January 12 = $2.41
That's not much of a loss. Conservative traders might have elected to take that minimal loss and step away until XEC sorted through the news. However, XEC's news-driven move does allow for an examination of real-life defensive strategies.
The first defensive strategy McMillan offers for consideration is the rolling-down strategy. To employ this strategy, two March 35 calls would be sold and one March 30 (or lower strike) bought. The trader would now be short one March 35 call and long one March 30. This strategy creates a bull call spread. It would be employed only if the trader believed that XEC would likely steady and climb again into March expiration.
McMillan imposes a condition for considering this strategy. Enough money must be made on the sale of the two higher-priced calls to recoup most or all the cost for the lower strike call. The option chain from January 26, shown above, demonstrates that the condition could not be met in this real-life situation. The March 30 was too expensive.
For simplicity, assume that sold options are sold at the bid and purchased options are purchased at the ask, although some effort might be made to split the difference in real-life situations. Under this assumption, selling two March 35 calls would have brought in $4.10 (2 X $2.05 bid) while buying one March 30 would cost $6.40. The credit received from the sale did not come close to paying for the March 30 call.
That's not going to meet McMillan's parameter, so this strategy must be rejected. However, for the sake of examining the strategy, imagine that figures on the option chain had been different and the March 30 ask had been $4.25. The spread could have been instituted.
Sell two March 35 call contracts at $2.05 bid = $4.10 credit
The original breakeven would have been $37.41 plus commissions. (XEC must have closed at March expiration $2.41 above the $35 strike before the original position began making money.) In this hypothetical bull call spread, an extra $0.15 would have been added to the original cost paid, but the new breakeven would lower to $32.56. Because the trader is now long a March 30 rather than a March 35 call, XEC must close $2.56 above the $30 strike before the position begins making money.
XEC has a much better chance of closing above $32.56 than $37.41, pointing to a prime advantage of employing this strategy. Risk, in this case the price paid for options, increased by only $0.15 in this hypothetical case. No wonder McMillan suggests this tactic for consideration when a losing position needs repair and the spread can be instituted for no or little additional cost other than commissions.
What's the drawback? First, traders must have margin accounts and permission to sell options to create the spread. In addition, although the breakeven level has been successfully lowered, future gains are capped. The trader employing this strategy with these hypothetical prices can never profit more than $2.44, no matter how much XEC might gain.
To see how this works, imagine that XEC closes at $40.00 at expiration. Here's how the results stack up:
Long March 30 call is worth $10.00 = $10.00 credit
Now imagine that XEC closes at $35.00 at expiration. Same $2.44 net profit. The sold $35.00 call expires worthless, your long $30.00 call is worth $5.00, and your net profit is that $5.00 minus the total $2.56 you paid for options.
The drawback of that cap on gains balances the benefit of lowered breakeven level at no addition price. Of course, this position offers no addition protection if XEC were to continue diving. If XEC were to close below $32.56 at expiration, some or all the investment is lost. The tactic still seems worth investigation when McMillan's parameters are met, but perhaps not when the original loss was only 15 percent.
Options pricing realities did not make this rolling-down choice available. The calculations were based on a hypothetical price for the March 30 call that did not exist. It is important to examine why McMillan imposes the condition that the spread must be established for little or no extra cost.
As of the January 26 close, establishing the spread would actually have required a $2.30 debit in addition to the $2.41 paid for your original position.
Selling two March 35 calls = 2 X $2.05 bid = $4.10 credit
Although McMillan allows that the spread might be established with a small debit, the total $4.76 cost would have been too high. That would have been only $0.29 below the $5.00 spread between the long March 30 position and short March 35 position. Imagine again that XEC closed at $40.00 at March expiration.
Long March 30 call worth $10.00 credit
With commissions subtracted from that maximum $0.29 profit, not much opportunity for profit existed using this strategy. In many other cases, the position can be established using McMillan's parameters and offering more possibility for profit from what was originally a losing position.
McMillan offers another strategy to repair a losing position. This one involves creating a spread, too, a calendar spread. In a calendar spread, a near-term call is sold against an intermediate- or long-term call of the same strike. Establishing this spread would have required selling a February 35 call against the original long March 35 call position. The option chain above suggests that the February 35 call could have been sold at a bid of $1.50.
Sell February 35 call = $1.50 credit
Net debit was reduced to $0.91. A trader might consider this tactic if XEC might be likely to linger at or below the $35.00 strike level into February expiration but then climb into the March option expiration cycle. If XEC were to close at February expiration below $35.00, the sold call would expire worthless. The $1.50 credit would be retained, and the trader would still own a long March 35 call, with the total cost now reduced to $0.91. Breakeven would again be reduced with this tactic, but not by as impressive amount. In this case, breakeven would be a close above $35.91 at March expiration ($35.00 strike plus $0.91 net debit) as long as XEC closed below $35.00 at February expiration.
Even if XEC closed the March expiration period below $35.00, costs were reduced and so losses were, too. However, this tactic proves riskier than the previous one. What if XEC closes above $35.00 at February expiration? If XEC expired below $36.50 at February expiration, the call seller would still retain some or all of the $1.50 credit received for the sale of the February 35 call, but there's a worse case scenario to imagine.
Imagine that XEC were to immediately spring higher. For example, if XEC had bounced to $38.00 by February 2, a week after its acquisition announcement on January 26, the CBOE options calculator suggests that the February 35 call might have been worth $3.13 while the March one would possibly have been worth $3.61. (This did not happen. As of Thursday, February 10, XEC closed at $36.31.)
Only $1.50 was collected on the sale of the February 35 call, so you're under water by $1.63 on that position.
Hypothetical value of sold February 25 call on February 2 if XEC at $38.00 = $3.13 debit to call seller
You originally paid $2.41 for your March 35 call, so you're up by $1.20 on that.
January 26 cost of March 25 call = $2.41 debit
The spread now shows a loss of $0.43.
Net debit on sale of February 35 call = $1.63 debit
Remember that the benchmarked loss on January 26, when XEC gapped lower, was only $0.36 or 15 percent. In this hypothetical scenario in which XEC had climbed to $38 by February 2, a scenario that did not unfold, the original loss was smaller than that incurred by creating a calendar spread.
This proves McMillan's axiom that a calendar spread should be avoided in instances when a quick bounce is expected. McMillan also mentioned the deleterious effect on call spreads when volatility expands, so this strategy would not work well at a time when volatility might be expected to expand, either.
The put buyer in a losing position can employ similar strategies, a rolling-up strategy that involves selling two of the owned put and buying one higher strike put, creating a bear spread, or selling a near-term put against long intermediate- or long-term long put position, creating a calendar spread. The bear put spread strategy may be easier to employ than the bull call spread one was due to some peculiarities in options pricing. Puts tend to hold their value better when a stock moves up than calls do when a stock moves down. It may be easier to find cases when it's possible to sell two of the owned put for an amount equal to the cost of a single higher strike put.
McMillan cautions that anyone considering these repair strategies understands exchange and brokerage margin rules to avoid incurring margin calls or restrictions against trading. If considering such strategies, traders should familiarize themselves with the strengths and shortcomings of each, too. Run through some numbers. Set up paper trades. Know when you'll close a spread if it moves against you. In what cases would it have been better to take the loss immediately? Averaging down is rarely a good idea, but when would establishing a bull or bear spread have worked? What about a calendar spread?
The good news is that if you had been that hapless holder of a March 35 call when XEC announced that acquisition on January 26, you would have had more choices than you might have expected. The bad is that you have homework to do if you're to fully understand how you might employ these strategies. This article wasn't meant to be a comprehensive review of all risks and benefits, but rather an introduction to the possibility of employing strategies to repair losing plays. Pull out your McMillan for reference, call up the CBOE options price calculator on your computer, and go to it.