OptionSage submits:
“Markets can remain irrational longer than you can remain solvent” – John Maynard Keynes
Much like
“Many people stake out spots near the water but, as the day goes on, the tide gets higher and the people move to higher ground. Some people go much higher and some people move just a little but there’s a certain point where the water crests up onto the beach and sends everyone scurrying for higher ground in a mad dash.
“Then it goes the other way!
“Just when it seems that the water is going to go higher than it ever went before (and, thanks to global warming it does!) and just when you start to think the next wave will wash over the top and soak everyone, it suddenly stops and an hour later you can’t believe you ever thought the water would get that high as it seems so impossible as you watch it pull away from the beach, exposing sand that hadn’t been seen since the morning .
“The markets are like that. Frothy highs and "impossible" lows and lots of investors scurrying back an forth trying to guess where the next wave will stop (day traders) while others stake out medium-term positions (deck chair people) and still others make substantial long-term plays (beach house owners) and are willing to ride out even the harshest storms. While I have fun playing in the waves I guess I have to think of myself as a shell collector, looking for the opportunities that are uncovered once all the excitement dies down. Let the other people get soaked trying to guess the waves – we can do very well renting deck chairs in any market!”
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In the stock market, renting deck chairs is akin to selling options (in this case call options). Always a buyer is on the prowl for the next great deal (the long call purchaser) and we can happily settle on terms (strike price and timeframe), content in knowing that nobody can take the premium we receive away from us (upon assignment or at expiration, we realize our gains). Only if we buy back the options at a loss do we lose money. But as we will see there is no reason to do that since we can modify the position instead.
When holding the underlying stock and short calls, our cost basis is below the short call strike price and, even if the stock gaps up and we are assigned, we make money. However, when we hold long term long call options, rather than stock, as a hedge against those short calls, assignment is generally not what we want at all!
In Phil’s Wave Theory, we can see the movement of the waves often surprises the beach-goers. The waves tend to move much further than expected. So too can the markets move much further than expected (see the Dow’s 300 point gain on Thursday and Friday ). This leaves the short call seller in a predicament!
If short calls are hedged by longer term long call options as part of a calendar trade, assignment is certainly not desirable. The trader is buying the right to buy the stock at a certain price while simultaneously is getting paid to enter a contract that obliges him/her to sell stock at the same price upon assignment. Since it costs more to buy the right than is received selling the same right for a shorter time period to somebody else, it seems like a really bad idea to take assignment of the short call and offset it with an exercise of the long call. And it is! You never want to end up buying and selling a stock at a certain price and have it cost you money (100% of the risk!) for the privilege!
Instead it is often much more prudent to remain with your big picture thesis – long term bullish (since the long call was applied long-term) – while modifying your short-term outlook. Certainly your initial expectation was for the stock to remain below the short call strike price or at worst not rise much above it by expiration. In the event that it does rise unexpectedly above the short call strike price, it’s much more prudent to modify the existing positions than simply to take a loss.
In fact, as stocks gap up we are generally left with one of three choices:
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Take assignment of short call
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Roll the short call
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Add a long call
As previously mentioned, Choice #1 is fine when we have a stock hedging the short call but it is not the preferred choice when holding long calls against those short call options.
That leaves us with choice #2 or choice #3. In fact, choice #2 can really be divided into two categories:
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2(a) – Roll the short call up in strike price and out in time for a credit
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2(b) – Roll the short call up in strike price and out in time for a debit
Rolling for a credit just means buying back the original short call option and selling a new short call for more premium in order to produce a net credit overall into your account. This is almost always the preferred choice because it means two things are occurring:
- Profit Potential Increases – since the short call is at a higher strike price, your profit potential is not limited until the stock reaches those higher levels and you profit in the interim.
- Cost Basis Lowered – when you take in a net credit from the rolling operation you reduce the overall cost and risk of the trade.
A question often arises then “Which strike price and what timeframe should the option be rolled to?”. And the simple answer is “whichever one produces a credit!”. Of course if you were more bullish you would tend to roll to higher strike prices if possible or if bearish to lower strike prices but in general sticking to the rule of receiving a credit should serve you well. As much as possible make sure to keep the cost basis below the short call strike. It won’t always be possible – particularly when rolling the option down in strike price – but it’s generally preferable to mitigate against surprising reversals.
Rolling the options for a debit (2(b)) achieves one of the aims; profit potential increases. Unfortunately so too does cost basis though! And remember our goal is to maximize profits and minimize risk simultaneously when we modify positions.
The final possibility is simply to turn the trade into a ratio call backspread through the addition of another long call option so that even if the original trade has limited profit potential the new trade still has a degree of hedging and unlimited profit potential. For more on ratio call backspreads, please click here to view last week’s article.
Before signing off for the week, here’s an interesting link I came across which might be of particular interest given Phil’s weekend reference to market gains in the context of currency devaluation. Personally, I’m a big fan of #43 – maybe because Sage has the same name or maybe because he is credited with the invention of puts and calls and gave us all here endless hours of entertainment and profitable career too (we’ll ignore his transgressions!).
Have a fantastic week!
OptionSage
