We all know that averaging down is a losing proposition: you throw good money after bad and increase your risk. Also, cutting your losses short is one of the most important rules of trading.
However, there is a strategy, using options and vertical spreads, that allows you to lower your break even point on a position that went against you. And to do it without increasing your risk.
If you own a call option and have an unrealized loss in this position, you can improve your chances of breaking even by "rolling down" into a vertical spread. You do it by selling 2 of the calls that you are currently long (the one that you own plus another one), and buying one call at the next lower strike, ideally for even money.
Let’s see how it works through the use of an example:
AAPL is at $114 and you buy Oct $115 call for $3
Stock drops to $112, you now need a $6 move before expiration to breakeven. You need the stock at $118.
Now, let’s say that at that time the Oct $115’s are trading at $1.50 and the $110’s at $3. You then sell 2 of the 115’s (the one you own plus another one) and buy one of the $110’s for even money.
You now own a 110/115 vertical (Long the $110’s and short the $115’s). And your risk is the same as the original risk ($3)
Let’s say the stock goes to $113 at expiration. The $110’s will then be worth $3 and the $115’s will be worthless, leaving you with a net $3.
You just lowered your breakeven point from $118 to $113 increasing significantly your chances of turning a profit on this trade.
But more importantly, you did not increase your risk.
Of course, some potential reward had to be sacrificed. Your potential profit is now limited to the stock going to $115. But if it goes to $115 by expiration the 110 call will be worth $5 and the 115 will be worthless, and your profit will be 66%. Not bad for a position that was first going against you! Also, if you are very bullish and the stock starts going up fast, you can always roll the $115’s to $120’s.
This strategy is a great strategy to include in our swing trading strategy. In the situation where we bought 1/2 a position with a wide stop, and the stock goes against us in the direction of our stop but stays above it, we can use this strategy instead of buying the second 1/2. I will make sure to let subscribers to the swing trading virtual portfolio know, in comments, when we do this in future positions.
Of course, this strategy works in the same way for puts.
To learn more about the swing trading virtual portfolio (strategy, membership etc.), please click here
– Optrader
