Option Investor

Strategy Refresher

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With little portfolio activity to discuss, we thought it might be valuable to share a recent E-mail reply on the subject of position management. The reader's question concerned the minimum (or necessary) criteria for "rolling" a cash-secured put when the (sold) strike price is threatened by bearish activity. In fact, the decision to adjust, rather than exit, any position should be based on the same components as an opening trade: the technical and fundamental outlook for the underlying issue, the position's risk-reward ratio, and the probability of profit. In the OW portfolio, we do not advocate "rolling" each and every losing play to a lower (and/or future) strike price, but the technique can be a viable alternative to a losing trade. For readers who are unfamiliar with the adjustment strategy, here is a brief explanation:

Writing out-of-the-money puts on bullish issues is a relatively conservative technique but occasionally, a trader will be faced with an option that is in-the-money as the expiration date approaches. One of the most common methods for preventing a potential loss in this situation is the "roll-out" and it is used when the price of the underlying issue is relatively close to the strike price of the sold option. Remember, selling a put obligates the writer to purchase the underlying issue at the sold strike price. If the stock remains above the sold strike, the writer retains the premium for the sold option. However, if the stock price falls, the writer may choose to roll out and forward in his position, to avoid potential assignment of the stock. He can repurchase the puts that were sold initially and sell new, longer-term options. Generally, the new options are written at the next lower strike price, or in greater quantity so as to generate a credit. In this simple recovery method, no debits are incurred but a realized loss is taken in the short term. If the stock price continues to decline, the process is repeated. Eventually, the issue stock should stop falling and the last set of written options will expire worthless. At that time, the traders' overall profit will consist of the sum of all the previous credits.

There are two requirements for success in this strategy. The first prerequisite is that the underlying stock must eventually rebound and the second condition is that the trader have enough portfolio collateral to stay with the strategy even if the issue falls significantly. A large stock portfolio is best for this type of trading because the collateral required for (naked) option writing may be in the form of cash or securities. There are no margin interest charges and the positions in the portfolio are unaffected unless there is a need for additional funds to close the play prematurely. In addition, this approach offers a high degree of (eventual) success although in some cases, there may be an accumulation of losses before a profit is achieved.

Another method of position management involves the use of a protective stop order on the option to insure a profit (or limit losses) if the primary trend of the underlying changes character. The basic guidelines for establishing an effective trading stop suggests that the "limit" price should be at a point where primary technical support is evident. Most often, this will be a relatively small range reflecting the bottom of a basing pattern or trend-line established prior to entering the position. An important objective of this initial stop-loss order is to preserve capital if the trade goes badly and yet provide every opportunity for the position to achieve its maximum profit potential. If the primary trend is less defined, the placement of the stop will differ, depending on your overall risk/reward tolerance. One must also take into account the past movement of the issue when setting the loss-limiting order and with highly volatile instruments, this can be difficult as they often fluctuate by large amounts. Trend-lines, minor lows, and near-term technical support levels are used to assist in the correct placement of these stops. After the position has been initiated, and the outlook for the stock changes significantly, the stop may be tightened (mover closer) to guarantee a small profit if "stopped out" while still allowing for a larger gain and a possible resumption of the primary trend. Regardless of the manner in which you determine the placement of stop orders, there is one fundamental rule of protective limits that remains inviolate: Once established, protective stop orders on bullish positions (such as naked-puts) must never be lowered, no matter how favorable the outlook for the underlying issue appears.

A person who understands the need for a mechanical approach to trading but can not control his emotions is destined to fail in the market. One of the best ways to overcome a "reaction-based" mentality is to establish a plan of attack (before you begin to trade) that allows you take control of your feelings and remove the possibility of an impulsive action. Experienced traders use pre-determined profit targets and stop orders, as well as proven adjustment techniques for any strategies they employ and that is the fundamental basis for consistent profits in the business of trading options.

Trade Wisely!

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