PROPOSITION: There is no reason to (permanently) lose money on a DITM vertical spread position that is no longer DITM due to declining stock price, under the following conditions:
CONDITION 1: There is sufficient time value remaining in the spread.
CONDITION 2: There is the expectation that at some unspecified future date, the stock value will recover to move a declining spread back DITM
CONDITION 3: There are future expiration dates available to work with.
That a damaged spread, under these conditions, can always be rolled out to a further expiration date for approximately no cost. Theoretically this can occur for an unlimited time frame.
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DISCUSSION:
The purpose of the thread has always been to talk about what I consider an incredible investment strategy, and to figure out how to make it better, safer, more reliable, more immune to mistakes and mis-information, more immune to seasonal fluctuations or earnings reports or market manipulation or management screw-ups.
There has been discussion of hedging with puts. It simply does not work within the framework of this strategy. We may forget about the possibility of a silver bullet put strategy to shield DITM vertical call spreads.
I have used a tactic in the past with decent odds of success, called rolling a spread. In this tactic, you replace one or both legs of a spread with other options at a different strike price or expiration date. Obviously there are almost unlimited choices how to do this.
Other than spread manipulation, the only other decision is to hold or sell the spreads. This is the most used method for risk management. It is the best choice if the expectation for a company is really unknown or gloomy. What is supposed to happen is you sell off losing spreads and hopefully replace them with profitable spreads. There is nothing wrong with this tactic, if fact the tactic to be discussed in the âPropositionâ is a just variance of this tactic.
Of course Iâm only talking about DITM spreads, other option strategies have their own adjustment procedures.
There is another tactic that is available. I donât recommend or use this tactic because you can lose a lot of money if you guess wrong. The possibility of buying back one or more short calls that have greatly decreased in value (thereby showing a large paper profit) can be done. Now you have a huge shortfall in the long calls that more than offsets your gain from buying back the short calls. You also have lost the âprotectionâ of the short calls that was in the spread. But if the stock recovers before the expiration date you can make a larger profit.
Back to the âpropositionâ, let me use an example to make the point. What is the point? The point is that trading/investing is a mental game as well as a financial game. Making the decision to take a loss is one of the hardest things a trader has to do, and is often so emotional that they do it wrong. Too soon â too late â too much â not enough, etc. I also made the point is a recent post that the more you believe in the position, the more you will lose if your are wrong. Well, I mis-stated that. Not only IF you are wrong but WHEN (in the flow of time) you are wrong.
The difference between the option guys and the longs is TIME and leverage. What happens to our mental well being when we option guys can have as much time as we want, for free (approximately)? If so, the decision is not how much money to lose, but how long do I have to wait to collect my profits. A much less dramatic decision, donât you think? There is some rationality here, I admit, but there is validity as well.
Note: as Iâm writing this the market looks like a blown-up balloon that is suddenly released and flying all over the place. Traders are having fun playing with Gustav.
If you look at my trades, you will see I have several times rolled a spread On 6/08 I explained the term âhistoryâ. On 6/10 I went through rolling one leg of a spread. On 8/23 I rolled a spread out and down. Same thing on 8/25 with EWZ.
Now let me tell you what I should have done: I should have simply rolled out the spread to a further month using the SAME price strikes. Also, many of the positions I closed out at a loss â like SII, ECA, MDR, TIE, APA, GG, MTW â what I should have done is simply roll them out. It is not a disaster doing what I did, since I did put the money to work, but I think it would have been better to roll out.
Take a position I have right now: 10 CNX JAN 65/70 @ 3.7. CNX is jumping all around from 60 to 70. Who knows where it will be in Jan.
The spreads right now can be sold for 2.25. This represents a potential loss of $1450.
However, I can also buy the APR spreads for 2.3 or the JAN10 spreads for 2.10.
If I feel that sometime in the future, CNX will settle down to a price above 70, then I can gain more time for the spreads to work and turn a $1450 loss into a $1300 profit by exhibiting a little patience. And it doesnât cost me anything but time. The figures Iâm quoting are real taking into consideration bid/ask spread. This is also an action I will consider as I watch the price. Mentally speaking, taking a $1450 loss is gut wrenching and traumatic, but when tempered by the prospect of recovering that in the future with a good profit to boot is very appealing. Another thought. This intuitively feels like a smart options play, since the same market forces that are working against you now are working for you in the future.
It will take some time for me to understand what you are doing, but that's always true with us tech guys.