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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.

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Exercising at Expiration: A real world example

Hi Mark,

Let me first say that I have been reading your blog for a couple months and I found it very educational. I really appreciate what you are doing.

On your latest post about options expiration, you mentioned that you don't like exercising. In fact that is what I did this past Friday and I'd like your insight on that.

I bought 2 (Discover Financial Services) DFS 15/17.5 April 2010 call spreads back in December when they cost me $0.88 and DFS was around $15. DFS has since dropped below $13 but went up a lot after it bottomed. During the past two weeks I finally saw a way out with profit when DFS was getting close to $16.

On Thursday it gapped open to more than $16.50 and I thought I could close the spreads at $1.40.  I entered the order but it didn't get filled. I thought I'd wait until Friday and enter another order. Then on Friday the stock slides further and I can't even make it even.

I exercised and planned to sell ITM expiring in a couple months (Ask prices of the May and Jul $15 calls are $0.90 and $1.30) to get out with a profit. Of course I know that DFS may drop again but I am willing to hold the stock and write calls. Essentially I'm exercising so I can still hold the position when my Apr $15 calls expire.

What are your thoughts?

Thanks a lot.

F

***

Interesting scenario for you.

1) You have a plan.  Your plan is to hold the stock and write covered calls.  That's fine by itself.  The crucial part of this exercise is that you planned ahead and know what you want to do.

But I do have a question, and that comes later.

2) My problem with exercising, as a general practice, is that someone who bought an option for a specific reason forgets the original reason and suddenly owns stock.  Along with that stock comes a great deal more risk than the original trade.  That's just a bad idea, and cannot work over the long term.

When you buy an option (or spread), if your original premise doesn't become reality, accept that fact and exit the trade.

3) Here's the big question that makes me doubt that you did a smart thing.  And remember this is my opinion, it is not necessary for you to agree.

Quote 1: "Then on Friday the stock slides further
and I can't even make it even."

Quote 2: "I exercised and planned to sell ITM…to get out with a profit."

Quote 3: "During the past two weeks I finally saw a way out with profit"

My question:  Did you exercise those calls just because you refused to exit this trade with a loss?

Planning to write covered calls is a very reasonable idea.

Planning to write covered calls just because you refuse to accept that this position lost money is beyond foolish.  Because you mentioned it three times, I believe you don't really want to write covered calls.  Instead you are obsessed with getting back to even or earning a profit.

As an option trader, you must know that you will have winning trades and losing trades.  That's part of the game.  If you accept additional risk (and owning a $15 stock is substantial extra risk when compared with owning a call option), just to avoid a loss, you are going to incur some much larger than hoped for losses.  Yes, you will also turn some losses into profits.

I have my trade philosophy and you certainly should have yours.  According to mine, these are the points I believe that should matter to you:

  • Is it your thought that writing covered calls is the best play in DFS?
  • Is there no play, with less risk, that appeals to you more?
  • If you do want to write covered calls, is it a good idea to hold the stock naked long over the weekend?
  • Are you writing covered calls ONLY because you refuse to take a loss?

You had a choice.  Exit the calls and open a new position Monday (yesterday); hold via exercise; or buy the Apr 17.5 calls and sell the May or Jun call last Friday (if you had the margin available to make that trade).

My major comment is that the exercise is okay – but not if you did primarily to avoid taking a loss.

669


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