The Fun Part of Risk Management. Taking Profits. Part II

Part I

Unloading Insurance

Today's topic is about what happens when the market moves in a single direction, so I'm only discussing the situation in which you own calls (originally purchased as insurance, not as a directional play) that are significantly in the money and are worth real money.

As usual, when trading options, there is no single solution.  You must make a decision before expiration arrives.  Holding these options through Friday settlement (if trading index options) is an unnecessary gamble.

Here are some choices:

a) Hold through expiration – that means planning to sell no later than Thursday of expiration week.  Holding overnight for the Friday settlement is a risky proposition. 

I don't like this alternative.  Your Aug 460 calls were trading near $20 today.  Why take the chance that a market decline could erode all of that value?  No matter how good your portfolio looks if the market declines, don't lose sight that this is a lot of money to risk. And if RUT ends near 560, how will the rest of your portfolio look?

First suggestion:  If you want to maintain long options in August, sell the Aug 460/470 spread and collect a big credit.   If the market continues higher, you still have the same quantity of long options.  All you 'lost' is the the difference between $1,000 and the cash you collected to sell each spread.  Repeat as necessary.

This idea is not unique to front-month options.  When you own naked longs, there must be some price at which it no longer pays to hold them and it's okay to collect some cash by rolling one or two strikes.  But only for decent cash.  Don't be selling these 10-point spreads for $3 or $4.   

Second suggestion: Diagonal spread.  Sell Aug 460, buy an equal number (or possibly a slightly higher quantity) of an appropriate September option.   The strike price depends on the remainder of your portfolio and the strike price at which protection is needed.  Thus, you may need Sep 580C, or perhaps the 600 or 610 will be good enough.  It depends on which strike prices you are already short (or plan to sell) for September iron condors. Remember, you do NOT want to load up on options that are further OTM than your longs.  Buying a big bunch of those calls can work miracles (as it would have this month), but it becomes a ticking time bomb as the clock ticks.  You want options that are closer to the money than your shorts.

b) Plan to gradually sell these extra options, perhaps one at a time. If additional protection is needed, replace them with the appropriate September calls.  If not, then just sell.

c) It may not be your choice, but at some point in time, expiration will arrive and you can no longer own these front-month options.  So plan to roll out to September, as discussed above.  With this roll, you lose delta and gamma, and gain vega and theta.

If you already own September and/or October positions, plan to sell August insurance and substitute calls that expire in a different month.  Your current position dictates the good strike prices to consider buying.

d) Close everything.  Start over when ready for the next expiration cycle.  Obviously, if you want to continue to own the same position, don't make this choice.  If you already have Sep positions, the put spread is probably cheap, so you must decide whether you can afford to cover and roll it higher.  You do not want to get whipped if the market suddenly gives up the ghost.

No Saturday post this week, or next.


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