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The “art” portion of trading comes in when a trade goes bad, or we want to adjust the trade for some reason – we need to “fix” it. Fixing a trade is not necessarily a straightforward process – often one must think in an unconventional manner to find a workable solution to the problem. We must be flexible in our approach to problem solving, as we already have several positions in place, and we want to keep those that will help us, while eliminating those positions that will hurt us. After all, making an unnecessary trade not only costs us commissions, but will also cost us in the bid/ask spread (the difference between what the broker will sell us an option for and what they will pay us to buy the same option).
Let’s look at adjusting a Bull Call Spread (buying a lower-strike Call and selling a higher-strike Call, both with the same expiration date) when we have suddenly turned bearish on the stock. Our sudden change of belief in the stock can come about for any number of reasons, but generally is a result of adverse news on the firm or sector, a belief that the market as a whole has changed character, or the stock price action has suddenly turned around. In any case, if we no longer have faith in our Bull Call Spread, we will want to do something before we lose our investment.
We have several choices at this point, the easiest being to simply unwind our trade. Well, actually the easiest is to simply do nothing, praying that the stock will indeed come back. If the stock doesn’t come back, we will ultimately end up taking our maximum loss. However, let’s pretend that we are smarter than that and, at least in this case, are not in total denial on the stock’s movement. To unwind the trade, we buy back the options that we sold (the higher-strike Call) and sell the options that we bought to enter the trade (the lower-strike Call). This should result in a credit, offsetting at least partially, the debit we incurred upon entering the trade.
How much of a net loss we have after unwinding the trade will depend on a number of factors, including how much and which way the underlying stock has moved, how long we were in the trade, how much time is left in the trade, the increase or decrease in volatility of the options, etc.
In addition, there is the loss on the bid/ask spread in the options that will be absorbed in the transaction. The difference between what the floor will sell an option at and what they will buy it back at can be substantial. It will be at least 10 or 15 cents per share ($10 – $15 per contract) and can be $1 or more per share ($100+ per contract) on very volatile stocks. As you will be first buying and then selling the lower-strike Call and selling and then buying back the higher-strike Call, you will find that the slippage in the transactions (entering and then exiting the option) can be substantial. If you multiply this number by two (for the two legs in the spread) and then multiply again times the number of the spreads you purchased, you can be getting into substantial money. Thus, you will generally be guaranteed a loss on the transaction if you simply unwind it, except in very extraordinary circumstances.
Is there something we can do if we believe that the stock has changed direction such that we do not lose any money, and in fact can salvage a profit? Of course – we are using options!
If our belief is that the stock will continue downwards, or at least not turn up again, we can morph the Bull Call Spread into a Bear Call Spread. We can accomplish this feat by entering a very wide Bear Call Spread, selling the original long call that we purchased to enter the position and buying a call with a strike higher than our original short position. The resulting net position will consist of a short call from the original trade at a given strike and a long call from the new trade at a higher strike. The new spread will be a credit. The net position of the original Bull Call Spread and the adjusting Bear Call Spread will usually result in a credit (depending on the particulars of the individual options at the time of the two trades). If the stock then does not climb back above the short Call, you will end up with a profit on the combined trades.
As an example, look at 3M Company (MMM) as of March 17, 2003. The stock was basing around $125 since the previous December after falling from $130. By March 17, the stock had been climbing for three days in a row, and was up over $8 in that time, closing at $129.50. If we then decided that it was time for the stock to step up to its next level, we might choose to put on a Bull Call Spread. Purchasing (long) a July 125 Call and selling (short) a July 135 Call for a net debit of $5.80 on March 18 would give us a trade with a 72% maximum profit if the stock closed above $135 on the third Friday of July, and a breakeven of $130.80 (125 + 5.80 = 130.80). The basic risk curve is shown in Figure 1, below. As the stock rises above $130.80 (the blue line), the trade becomes profitable, reaching its maximum profitability at a stock price of $135.
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