Option Investor
Trader's Corner

Preparing for the Unthinkable

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Every few days, I do something strange. I practice closing out a position for a loss.

For example, earlier this week, the SOX was moving toward the sold strike on eight contracts of a bull put spread I had purchased just before the April option expiration. I'd taken in $0.50 in credit for each of those contracts. The SOX was still about twenty-five points above my sold strike that day, although it had made a closer approach earlier in the June option expiration cycle.

My broker, brokersXpress, allows me to move to the "Positions" page and then choose from a listing of choices that include "Trade/Roll/Sprd/Chain/Notes." Clicking on "Sprd" (Spread) on either of the two options in my bull put spread pulled up the following page about noon on May 31.

Order Page to Close Out Bull Put Spread

A sidebar to the left of the order form showed the bid and ask for each contract, as well as for the spread, on that date.

Bid/Ask Information

Obviously, the position would be a losing one if I had closed it out on that day, but to estimate how much I really would have lost, I would have had to estimate how much the 430/440 spread would have been worth if the SOX had been nearer 440. With the SOX about twenty-five points above my sold strike at the time, the quote seen above would not have been accurate. With the SOX at 465.30, I decided to pull up an option chain to look at the 455/465 spread. I could better estimate what it might cost to close out a spread with an ATM sold strike.

Option Chain for the SOX

That tells me that the ask to close out my spread would be closer to $4.20 (selling the proxy long 455 strike at the bid and buying the proxy short 465 strike at the ask) than the $1.70 that was currently being shown to close out my actual spread. Notice that the individual 455 and 465 strikes don't have a lot of spread between their bids and asks, either. Those who trade these SOX spreads know that it's not easy to reduce the price you're going to pay, so I'd probably be paying somewhere near that $4.20 to close out the spread, when I'd taken in only $0.50 to open it. Ouch.

I wasn't planning to close the play that day, taking a hefty loss, when the SOX was twenty five points above my sold strike. If I am lucky, the SOX is going to stay above my sold strike until option expiration, and time is going to evaporate premium from that out-of-the-money strike, and I'll keep all the credit that I'd collected when I initiated the spread.

So, why was I going through that practice exercise on May 31?

I go through that exercise every few days because I'm not always going to be so lucky as to have an index or equity hold above my sold strike. There have been times when I've had to close out a play when the sold strike was hit, and times when I've closed one after the sold strike was almost hit and then price temporarily bounced away, because I was fairly sure that price was going to come back and violate my sold strike. It's always a judgment call, but times exist when I might prefer a smaller loss to a possible larger one.

When I do have to exit when a spread is in trouble, and the exit is going to hurt, I want the decision to be almost automatic. More than that, I want the execution of it to be almost automatic. Practicing such exits every few days accomplishes several goals. First, I know I can do it quickly. For someone whose coordination isn't always the best and whose hands are sometimes stiffened by arthritis, physically practicing the play assures me that I can do it quickly. That removes some stress.

More importantly, however, it trains me to do this almost automatically. Each time I go through the exercise, I estimate, as quickly as possible, whether I should place a market order or a limit order, depending on how the market is moving. A limit order almost always is best, but if you've never chased an exit in a thinly traded security when prices are moving fast, you might not know that it's sometimes difficult to get out even if you're placing orders that indicate your willingness to pay the full quoted price. Prices are just moving too quickly. That doesn't usually happen if you're trading an index, but it certainly does on occasion when you've got a spread on a thinly traded equity. (That's why I don't do those any longer, but that's a topic for another article.) In addition to determining whether I'd place a market or limit order, then, I estimate what limit I'd place on that order.

I've found that, since practicing my exits in this way, I'm much calmer when prices approach my sold strikes. I trust myself to do what's needed for sound account management. Of course, this would work just as well if you were planning exits on single options positions, such as a long call or put, but I'm just not doing those these days so am drawing examples from spreads.

My broker requires a separate "Preview Order" selection before the order is placed, so I'm not fearful of inadvertently placing an order, although there have been times when visiting grandchildren have come close to sending a pre-staged order! If your broker allows "one-click" type trading, you obviously can't set this up and practice in the same way I do, but you still can call up an options chain and practice estimating your exit price.

Make it automatic, or as automatic as is possible. Some inevitable day, you'll be glad you did.

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