By Josip Causic, Online Trading Academy Options Instructor

After my article, Bear Call Gone Bad, I have received several emails requesting the trade fix. The aim of this article is to examine at least one of these possibilities. Again, I am not recommending anything but only explaining the mathematical side of this "fix," and it involves a two step procedure.

The first one is closing of the March Bear Call and simultaneously rolling it into another spread in April. At this point, the trader has a choice of completely reversing the market outlook from being Bearish on the market to being Bullish on the market. The student whose trade I discussed in last week's article is now more concerned than ever and the conviction of the student is that the market is still going to go lower. Therefore, honoring the student's P.O.V. (point of view), after all it is the student's trade, I will look into replacing the existing March Bear Call with the April Bear Call in an attempt to salvage the trade or whatever is left to be salvaged.

Let us dive into the specifics. Again, this article is the extension of the previous one (Bear Call Gone Bad), and I suggest that readers do not attempt to grasp its content without having read it too.

This is the current position that the student has:

BTO + 100 Mar 14c @ -0.505 (OTM)
STO – 100 Mar 13c @ +0.70 (ATM)
Max P (is the difference) + 0.195
Max L (width Spread 14c-13c) 1.00 –Max P
Max L -0.805
ROI = Max P/Max L = .195/.805 = 24.2 %
BEP = sold strike + Max P = 13.00 + 0.195
BEP = 13.195

As it could be observed, the breakeven point of 13.195 was approximately where the student changed his Bullish stance (of owing just long March 14 calls) into the Bearish stance turning his long call into a Bear Call by selling against March 14 call, the lower strike price - March 13 call.

At that point the student has received both the credit for 0.195 times the number of contracts that were involved in the transaction. At the same time, the student had a HUGE maintenance placed by the broker until the expiration. In the last article, I chastised the student for the position sizing; hence, in this one, I will leave this issue of over-sizing out of the discussion.

Having recapped the facts, let us go back to the original question: "How can a Bear Call gone bad be fixed?" It all depends on where the market is and how many days are left until expiry. Why do I say, "How many days are left until expiry?" Within the week of expiry the traders are no longer in charge of their positions. Let me get more specific - during those last three or four trading sessions, the market makers could widen the spreads for those traders who are trying to get out of their losing positions for the front month. Let me ask the readers: "On whose side is time, during that period?" Is it on the side of the traders whose trade had gone bad or on the side of the floor traders who have to be there until 16:15 EST (Eastern Standard Time) regardless if the trades are coming through or not? What do you, the reader of Online Trading Academy community think?

It is during those three – four days before expiry that the traders are at the mercy of the market makers? (In one of the subsequent articles, I will come back to this point and elaborate on it to a greater extent).

Besides knowing how many days are left until expiry, we also need to know specifically where the market is for the product that we had traded. In our example, the student has entered this position around 13.20 and since then he has passively monitored his position as it was going against him. At the moment of writing this article, the product, which we should again call XYZ, was trading at 14.60 which would be one dollar and 40 cents higher than where the Bear Call was entered.

Now, let us go back to using one of those charts that I had created last week. In the case of price being at 14.60 on the day of expiry, the student would have the maximum loss, which was scenario number 2.

Scenario # 2 (Bad outcome) XYZ $14.6

Bottom line = - 0.805

With the price being at $14.60 the sold 13c is now worth 1.60 and it needs to be repurchased for much higher price from what was sold. Observe that it was sold for 0.70 cents and now needs to be bought back for 1.60. In this case the loss is 0.90 per contract. However, the trade has gone sour, yet the max loss isn't 1.60 because of the fact that the 14 call which was bought for 0.505; it is 0.805 (times the number of contracts involved in the transaction).

Figure 1

Figure 1 above shows the option chain for the March at the time of writing this article. Look at the price for the March 14 and 13 calls. Observe that I have circled the price which needs to be paid in order to exit both of these positions.

Closing the March Bear Call XYZ $14.53

Bottom line the loss = - 0.555

Where is the fix? The fix would come at the simultaneous repurchase of March and sale of April Bear Call. Again, going back to the student's stance: "The market will go down! If not by March expiry then by April's expiry!" Hence, let us simply exchange the months keeping everything else in place. Figure 2 below shows the option chain for April.

Figure 2

The outcome is:

BTO + 100 Apr 14c @ -1.00 (OTM)
STO – 100 Apr 13c @ +1.65 (ATM)
Max P (is the difference) + 0.65
Max L (width Spread 14c-13c) 1.00 –Max P
Max L -0.35
ROI = Max P/Max L = .65/.35 = 186 %
BEP = sold strike + Max P = 13.00 + 0.65
BEP = 13.65

The numbers mathematically might look appealing but let us stay grounded in reality. If the student closes his March Bear Call for the loss of – 0.555 and then receives + 0.65 producing the difference of + 0.095; "How much of the profit is there?" The March loss and the April premium get subtracted, while the same maintenance on his account is in place, which is huge, ten thousand dollars. Now, is it worth it to have such a big chunk of money sitting in maintenance for the entire month? This is the question that the student needs to answer; moreover, XYZ must close below 13 in order for the maintenance to be lifted. Is it worth it to prolong this bad trade?

In conclusion, I was asked to provide one of the possible scenarios for fixing a bad Bear Call. I presented a "rolling out" strategy without suggesting that it is a good solution. Notice, in this article, there are not charts and no technical analysis. It is all mathematical calculations of the possible losses. Lastly, let me leave you with the final thought: this strategy of prolonging the taking of loss could go on indefinitely, month after month, year after year. Yet keep in mind, "What is the goal of trading? Avoiding something or making something?"

Have good trades and again, monitor your positions closely.

- Josip Causic

DISCLAIMER:
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results.

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