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Managing a Collar Position in a Declining Market II

Part I

6) I note
that you had planned to sell Jul and then Aug calls in an attempt to
recover part of the premium you paid to own September puts (and stock). 
There are many who suggest that owning collars composed of long-term
puts and short term calls is a wonderful strategy.  The truth is, that
it can be profitable under two conditions:

a) You buy
those long term puts when IV is low.  If you pay up for longer-term
options and IV gets crushed, so does your position

b) The market
does not move too far in either direction.  This allows you to sell
those Jul and Aug calls as planned

I note that you made this trade
near the market highs, so perhaps you have the advantage of owning the
puts at a good price.  But the market has moved too far and you are
losing money as it slides.

7) You are correct that the Jul an Aug 121 and
122 calls are hardly worth selling.  My question is:  Why would you want
to sell those specific calls?  

I know the answer, and your situation is
common.  You bought stock at a price over 120 and you insist on selling
OTM calls against them.  The fact that the stock has declined to 108
does not deter you.  This is a blind spot for many traders.  More on
that later.  Cliff, you obviously recognize that selling calls with such
high strike prices is not going to do you any good – unless you get to
see a miraculous market rally.

You can wait for that rally, but it's not a
good way to invest.  It's possible, but you know the probability is very
low and you must find a way to make money with this position – starting
today.

This may be difficult to accept, but if you learn to accept it
you will make more money over your career:

I believe:

I. Money that
has been lost has been lost.  Forget about it

II. Your goal
is not to break even from that losing trade

III. Your job
as a trader is to make money starting right now and into the future

IV. Your job
as risk manager is to guide your trader persona into owning positions
based on reality and not hope

V. This means you must forget the price you
paid for SPY.  It's 108 now and that's the situation you with which you
must deal.  That means writing calls with a strike over 120 is no longer
viable

8) Here's another blind spot. You are naked long Sep 120 calls
and you fear that if you write calls with a 115 strike price the market
may head higher.  You are long.  Why fear a rally?  A rally is your
friend.

I get it.  If the market rallies too far, then you will have
locked in a loss by selling the 115 call.  No one likes to 'lock in a
loss.'  That's why I believe traders must forget their entry price and
manage a position to make money from today – not from some time in the
past when the trade was initiated.  That's ancient history.  You can
only trade for the future.

Note the blind spot:  It's okay to lose money
on a decline (that must be true because you have been trading with long
delta), but if you sell the 115 call and the market rallies, that would
be a bad thing, even though you would make money.  I hope you can see
the inconsistency there.

If you do sell that call and the market does
zoom back to 120, isn't that a good thing?  You will have earned money
from today forward.  And if you do the right thing with the puts and
roll down to a lower strike, you will prosper should the market move
back to 120.

9) Bottom line reply to your question: How
would I handle this?

I would forget my original trade.  I would
cover the Jun calls, probably at $0.05. I would sell the Sep 110/120 (or
perhaps the 112/120 or the 108/120) put spread and collect a bunch of
cash.  Then I would choose a call to sell.  Most likely it would be a
September call because I do NOT like owning
collars when the long put is long-term and the short call is near term
.

Better yet,
instead of working a collar, I'd close all three legs and open a
different long call spread (or short put spread).  Why bother with the
three-legged spread when you can own the equivalent two-legged spread?

You currently
have this call spread:  long Sep 120; short Jun 122 SPY call spread.

If you do what
I suggest on the puts and make a decision on the calls, you would own
the equivalent of Long Sep 110C (or other strike); short Jul 115
call.

That's a very vega rich, long delta position.

Cliff: I do not
want to confuse you.  If you wind up with the call spread – be
absolutely certain you do not also own stock.  If you prefer to trade
the collar, then you would hold a Sep put (strike near 110) and be short
some Jul or Aug call.  Perhaps the 115 you suggested.  I have no
opinion on which call to sell.

700


Expiring Monthly; May 2010

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Managing a Collar Position in a Declining Market

I received an important question from a long-time reader.  There are several important lessons embedded within this question:

Mark,

I am long SPY at about 121.50 and protected by long September 120 puts. I sold June 122 calls against the position to defray the cost of the long puts (which, I believe, is something you advocate). I plan on selling additional calls in July and August to further reduce the cost. However, as SPY drops, the premium on the 122 and 121 calls is diminishing to almost useless levels. If I were to sell a lower call with a higher premium, like a 115 or thereabout, I risk a reversal in the market.

How do you suggest handling this set of circumstances?

Cliff

***

Thanks for this very interesting question.  This discussion allows me to cover more than one of my favorite 'philosophy of trading' scenarios.

1) You own a SPY Sep DITM put (SPY is currently 108) plus stock.  You don't state how many puts you own, so I am going to assume you own one put for each 100 shares.

That means your true (equivalent position) is long SPY Sep 120 calls. 

2) Obviously this is a position that is delta long and does not fare well when SPY declines.

3) Here's
the very first thing you should do. ADDENDUM: Tuesday morning.  Markets are even lower.  Rolling the put is still right, but it's even more difficult to choose which call to write now.  IV will give you a better premium, but which strike?  You do not need to hold a $15 put
to protect stock.  Sell that expensive put and replace it with another
put.

If you prefer to remain long vega, buy a Sep put with a lower
strike price.  How much lower?  I cannot tell you, but you want to get
some cash out of this position.  There are two ways to do that.  The
first is to roll down the put, as suggested here.
Or
use some of that cash to buy an extra put or two
.
  The second is to sell
a new call option.

Note that if you sell the 120 puts and buy 110
puts, then your position will be long the (synthetic) Sep 110 calls. 
You will no longer fear a rally.

4) You are short Jun 122 calls.  These may have been ATM calls when you made the trade, but they have been offering almost no downside protection for the last several points that SPY declined.  

For all intents and purposes you are naked long Sep 120 calls.

5) I am in favor of selling calls when you own stock and puts, but when the put is 12 points ITM and the call is trading near zero, that's not a hedge and is not something I advocate.

Nor do I like the idea of owning long-term puts and writing short-term calls when trading collars.  These can be spectacularly successful, but are far too risky for me.  They may be okay for you – as long as you understand the extra risk inherent in these stretched collars.

There are almost 4 weeks remaining until the Jun options expire.  The Jun 122 calls last traded at 4 cents.  I can understand not wanting to waste money, but there is absolutely nothing to gain by waiting almost 4 weeks for these options to expire.  You are naked long the Sep 120 calls and unless you want to own that position, you should be doing something.  In fact, it's rather late.  But better late than never. Bid something to buy those options.  That frees you to sell other call options and complete the collar.

to be continued


699


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