Controlling the Direction of Option Trades
When used for directionally trading in the market, options offer excellent position management and risk control capabilities. This is more involved than just remembering that the maximum loss from a long call or put option position is the same as the option's price (plus commissions, of course). Just that alone is incredibly helpful. To maximise return while keeping risk well constrained, this article discusses a couple of handy little things one can do while holding an option position.
Raise and Lower
The idea of a trailing stop, whereby one's protective exit is moved as the market moves in one's favour, is well-known to most traders. This is employed to secure earnings. Trading options instead of the underlying allows one to achieve the same result. Depending on whether the trade is long using calls or short using put options, one can achieve this by adjusting their position to reflect the change in strike prices.
This piece is based on the author's own trading experiences as of late.
At about 21.50, I bought some March 22.50 call options to start a long position in Seagate Technology (STX). They cost eighty cents. After a few shaky weeks, the market finally broke $24. Soon after, the 22.50 March calls were sold for $2.60 and the 25th March calls were bought for $1.40, completing the roll-up. There were two goals achieved by this move. The first is that it removed $1.20 from the equation, which decreased the portfolio's exposure and released funds for other uses. With the $2.60 sales price minus the $0.80 buy price of the 22.50 calls and the $1.40 buy price of the new 25 calls, it locked in a profit of $0.40. However, the remaining potential for the trade's upside was unaffected. Any additional increase in the price of STX shares would likely result in roughly equal profits for the two strikes.
Another option would have been to sell the 22.50 March calls and roll all the money into the 25th March calls if the portfolio exposure was considered acceptable at $2.60. Selling the 22.50s would result in $2600 if the position consisted of 10 options. With $2600 divided by $140, or 18.57, you could have bought 18 of the 25 options. Doing so actually raises the trade's potential profit margin. Of course, the entire position is vulnerable; losing all $2600 invested is a greater possibility than losing nothing at all when the trade was initially started.
Continue onward
The short time frame in which options allow traders to hold a position is one of their major drawbacks. This can be a significant obstacle for traders with intermediate to long-term strategies. Still, one can extend the holding period of a position by rolling forward the expiration month, just like the roll up/down.
Looking ahead, we can examine the STX example. To do that, just switch out the March contract for the June one. Right now, the 25s for March are selling for $2.40 and the 25s for June are selling for $3.60. However, there is a catch. The longer the time to expiration, the more expensive the June contract is. Thus, a roll up/down is frequently the most effective way to perform a roll forward.
Just think back to the 22.50 call to 25 call roll-up that happened earlier in STX. To move forward and up, we could skip to the call on June 25 if we were still in the former. At the moment, the 22.50 option is selling for $4.10. We could complete the roll up and roll forward while removing $0.50 from the table if the 25th of June was priced at $3.60. Although it falls short of what we achieved with the roll up, it does add three months to the time we could remain in the position. The expected holding time for the trade determines if that is worthwhile to trade.
Efficiently managing strike prices and expiration is a breeze. Over the past few years, individual traders have seen a dramatic decline in the transaction costs associated with options trades. As a result, a plethora of opportunities for directionally playing the market and efficiently managing positions become available.
