Exercising at Expiration Follow-up: A real world example

Hi Mark,

Thanks for your suggestions on my DFS trade. In fact I should have mentioned that a majority of my option positions are OTM credit spreads and iron condors.  This is the one or two speculative positions I have at a certain point. I entered the trade back in December anticipating DFS to go up, and it did. I do admit that I committed the sin of being emotional with my position and want to make even, but in this case, I also believe in the company and I do own the stock in another account with a higher cost basis. I was in a similar situation late last year, took a loss but slept well.

1) When you opened the position, and the price you paid are immaterial

2) Your position may have been born short a put spread, but now it's a naked short put

3) You 'believe in the company'?  What does that have to do with the price of tea in China?  Is owning naked long stock (or a covered call) the way you want to play this company going forward?

4) The fact that you own more stock in another account is immaterial.  Although the fact that you are already long with downside risk ought to encourage you to take less risk in this account

The cost basis of your stock is immaterial.  Only the IRS will care about that – if you ever sell the shares.

5) It is not a 'sin' to get emotionally involved with your decisions.  That's a trait that is difficult to overcome, but it is necessary if you want to be a successful trader or investor

It is not a 'sin' to try to get back to even.  However, it is an exercise in bad judgment. You obviously plan to continue to trade.  It should not matter which stock, or which specific position, provides profits.  Your goal is to earn maximum profits with minimal risk.  You are not doing that with this position.

6) One way to break that 'get back to even' mentality is to ignore your entry price for a trade.  Write it in your journal, but do not pay any attention to that price.  Pay attention to current risk and reward.

I recognize that my stance on 'forget about break-even' is the minority view, but I stand by my belief that it's the only view that makes sense.  Consider this:  You hang onto a trade to get one more dime out of it.  You need that one more dime to break even.  While waiting for the dime, the stock moves and you lose two bucks.  Nice risk/reward.  Maximum gain is a dime, maximum loss is ???

On the questions you raised, this is what I think:

Writing covered calls the best play? By the middle of expiration week, I have a couple plans in place:

Plan A: Close the spread with nice profit.   That did not happen 

This an example of you making a trade decision based on profit or loss and not on risk/reward.  It's your money, but this is not a good idea – in my opinion.

Plan B: Short DFS stock so I am completely out of the position by Monday.   I was going to do it on Friday if Plan A didn’t work, but DFS dropped further, so I decided that was not the best time to lock in an exit price 

Again, a decision based on the fact that it would lock in a loss to exit.  This is not a good decision based on risk/reward.  You are free to trade that way, but my recommendation is to learn to think differently.

Plan C: Exercise the $15 call and let the $17.5 call expire; then exit in the near future.  I chose to write covered calls.

A viable plan.  A reasonable strategy.  However, if you chose this backup to a backup plan just to avoid taking a loss, it's no longer a viable plan. 

There is one thing that I did not think about, and that is to roll the position to a later month.  I usually view different expiration dates independently, and I did not have the work done the night before. I guess I should start looking into this possibility. 

Sure, be aware of the possibility. Plan ahead.  If you can get a price you would be happy to get to roll, then this is a good plan.  But rolling just to do something – which is what you did this time, albeit with a weekend long leg – is a bad idea. 

Rolling is not some magical trade that turns losers into winners.  It's a decision to exit one trade and enter another.

Less risky plays? This position as I explained earlier, is one of the speculative positions I have, so by design if I lose 100%, I will be fine with it (on this one, I see that with a little more time I can turn that to a profitable position). I used to speculate with vanilla long calls but I do not feel comfortable with that any more.

When this trade was made, losing 100% meant a loss of $88.  Now it represents a potential loss of more than $1,400.  Are you still willing to lose 100%?  Is this a good speculation?  Are there no other bullish plays that satisfy you?  Must you own stock?

Let me see if I have this right:  You do not feel comfortable with the risk of owning calls, but you are ok with the risk of owning stock? That's not how I measure risk.  But the nice thing about options is that there are so many alternatives that we can each take the risk we are willing to hold.

Naked long over the weekend a good idea? Acceptable, I’m comfortable with it.

Covered calls ONLY because I refuse to take loss? Part of the reason why I exercised, but I also believe in the stock itself.

Gibberish.  If you believe the stock is moving higher  – can't you find a less risky way to be long?

Once again, thanks very much.

Thanks for the question and follow-up.

F.

672


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7 Responses to Exercising at Expiration Follow-up: A real world example

  1. 5teve 04/24/2010 at 8:24 PM #

    Hi, Mark
    For kite spread, you usually use c3, c4 variety as examples, do you use c2? for instance, buy 1 rut 760c, sell 2 rut 770/780 spread. or the larger the c# is the better? Thanks

  2. Mark Wolfinger 04/24/2010 at 10:29 PM #

    There is nothing wrong with a C2, but I avoid them. I prefer more distance between my long option and my shorts.
    Personal preference. That’s all. I look at the C2 as a butterfly with an extra long call at the wing. If the market heads towards that upper wing, the fly loses it’s value but that extra comes into play.
    In this example, if that extra 780 has a lower strike price than the call spread I’m defending, then yes – I would be willing to make that trade.

  3. 5teve 04/25/2010 at 12:44 AM #

    Hi,Mark
    Thanks for the quick response. 1) “more distance between long option and shorts”, then you have to sell more spread, does it make the margin requirement go up? In case of c4,c5 or more, there is significant increase on margin. Am I right?
    2)Will you consider following trade as a good protection: I sold rut 660/670c spreads,as the rut goes up at 641 now. For protection, I closed some 660 calls,keeping the 670c and sold some 680/690 spread.
    3)when trading kite, I realized I have to trade them separately instead of all-in-one trade. Is it possible to trade all legs of kite at the same time? when trading separately, you may get part of kite filled while other part still open, then it makes you under pressure and try to rush to complete the whole trade.
    Thanks

  4. Mark Wolfinger 04/25/2010 at 9:02 AM #

    Hi 5teve,
    1) Yes, margin is higher with C4 or C5. The margin is based on number of spreads sold. But you can do C (4-1) kite if willing to pay extra cash. This refers to selling the call spreads appropriate for a C4, but selling only 3 of them.
    Cash collected is less, so kite costs more when you trade a C4. But shorts are farther OTM. It’s a trade-off.
    A C4 or C5 kite may sell call spreads that are so far OTM that selling them returns nothing. I don’t like that trade.
    In general C3 looks best for my comfort zone. But it does depend on the specific circumstances.
    2) Yes. I did the same spread myself. (June options)
    3) Yes, I can do them in a single trade, but ONLY when the ratio is 3:1 or less. My broker’s (IB) computer rejects C4 kites. In that case, I do the C3 kite (as a single order) and then sell the one extra one-lot. And if I miss that 1-lot sale due to a moving market – it’s ok.
    Good questions.
    Regards

  5. 5teve 04/25/2010 at 9:34 AM #

    Thank you ^^, Mark

  6. F 04/25/2010 at 10:59 PM #

    Hi Mark,
    I think you have taught me a lesson on not to get fixated on cost basis. I have to tell you that cost basis is the thing I am obsessed with since day one of investing and still is at the moment. It would take a long way to move away from it but I’ll take your advice to focus more on risk/reward.
    However, I disagree with you on one thing, which is when you compared the risk of holding stock vs long calls/call spreads. It is obvious that I can easily lose 100% of my call/call spreads. It is also possible to lose 100% if I’m long stock, but the possibility is very remote. In terms of absolute dollars, the amount I can lose in a short period of time is going to be a little more than the maximum loss in options, but it is very unlikely that I’m going to lose all my money in DFS.
    Long calls to me is a short-term speculative play and long stock is for a longer term, and I am comfortable with my stock positions not hedged. The amount I allocate for stocks are a lot more than I allocate to options (since I’m still a relative rookie in options). The amount of money I am willing to commit to one option position can only buy me some very OTM calls (which normally don’t end up ITM) but can get me spreads that are more profitable to me. That should explain why I’m comfortable with long stock but not the long calls.

  7. Mark Wolfinger 04/26/2010 at 7:45 AM #

    F,
    You raise interesting points that I cannot answer briefly.
    Full reply tomorrow (Apr 27, 2010) as a blog post
    Regards