By Josip Causic, Online Trading Academy Options Instructor
The goal of this article is to point out that it is of utmost importance to be familiar with the product on which we are trading options. At any given time we should be aware of many factors which come into play when trading options, such as earning releases, dividends, implied volatility, and also technical analysis which determines the proper timing for both entries and exits.
In a couple of my previous articles I have addressed an over-leveraged trade by one of the readers. It had gone bad and the trader supposedly held it until the expiry, achieving the maximum loss. However, after the March expiry, I learned that his bad trade which has already been cleared out of his account was still haunting him both psychologically and financially.
In order to get the most out of this article I suggest rereading "Bear Call Gone Bad." It is there that I have specified all the prices that were paid. Here I will just give a big picture of what happened by utilizing Figure 1, which gives the chronological layout of the trade.
# |
Date |
Price |
Action |
My comment |
1 |
Feb 9 |
16.00 |
Bought long directional March 14 calls |
Bullish outlook |
2 |
Mar6 |
13.74 |
Added more to March 14 call & then sold March 13 calls |
Bearish outlook |
3 |
Mar19 |
15.16 |
Assigned on 87 contracts of sold March 13 calls |
Market went up |
4 |
Mar21 |
15.30 |
Trade cleared out of the account |
Saturday action |
Figure 1
In order to best understand Figure 1, I have also included the chart of XYZ, which has several markings on it.
Figure 2
The chart above has the number sign in the first column and we will use those numbers as the events that guide us. Now let us go through the whole trade:
Event # 1
On the chart, the first blue oval on the left marks Event #1 (LE for Long Entry). Figure 1 gives the price level and the date on which the trade was initiated. XYZ was initially a bullish trade, yet the entry was wrong, for it was entered as the price was coming to its resistance. It was a directional option trade with straight calls for the front month at the strike price of 14. Once the trade had gone wrong for several days, the trader (let us name him Trader Joe) recognized that the trade was NOT working out the way he anticipated, so he threw more good money on the bad trade to basically bring down the initial cost of the premium for the March 14 calls.
Event # 2
On the chart I have marked the second oval representing the point where the trade was changed from having a Bullish outlook to a Bearish one (SE for short entry). By selling March 13 calls, Trader Joe turned a bullish trade into a spread trade. In hindsight it is so easy to observe that instead of turning it into a Bear Call (vertical credit call spread) he should have turned it into a Bull Call (vertical debit call spread). Yet the fact is that Trader Joe’s prediction of the stock market direction at that point was wrong. His initial assessment after all was accurate, even though his initial entry point, going long at the resistance, was off. Personally, I find that most of the time my initial, gut feeling is correct and every time I second-guess myself I regret it.
At any rate, by turning the losing Bullish directional call into a Bearish Credit spread, the trade could bring a return of 21% on the investment. Strategy-wise the play makes sense, yet what about the timing of the strategy? Does the technical analysis confirm the decision to sell the March 13 calls? Has the price on XYZ ever traded below 13?
The end of Trader Joe’s Bear Call play was never reported to me. He did email me asking for a possible solution. Please review the article "Prolonging the Pain of a Bad Trade?." I honored his bearish stance and described the whole possibility of rolling the March Bear Call out to the next month, without ever suggesting that it was the right thing to do.
Events # 3 and 4
Both of these events happened within days of each other. Thursday, the day before expiry is marked with the green rectangle, yet the day after expiry is not on the chart for the simple reason that the market was closed on Saturday.
Anyhow, a week after the March expiry, I received the email revealing to me the whole outcome. The trade was never rolled out to the next month but it was held to the expiry. Apparently, Trader Joe achieved the maximum loss, for he was assigned on his 87 sold contracts on Thursday before the expiry. His long March 14 calls were exercised on Saturday following the expiry. The account of Trader Joe has shrunk by $10,000 minus the premium received for the sale of his March 13 calls. One would assume that this is the place where the story ends, for he has achieved his max loss, but no, there is more to it.
To make matters worse, something BIG was overlooked. Stocks do pay dividends to their share holders, while those who have shorted those shares end up paying the dividends. Unfortunately for Trader Joe, the product that he traded in March paid out dividends on Friday of March expiry. On Thursday the day before, he was assigned on 87 contracts, each controlling one hundred shares, the dividends were paid out. They were paid out at the rate of 0.077 cents per share. In his case 8,700 shares times 0.077 netted to $669.90 of additional cost to his already losing trade. This amount of almost $670 dollars was taken out of Trader Joe’s account a week after the whole trade was settled. After several emails back and forth I figured out that what happened was Maximum Loss plus reverse dividend. When questioned about closing out his sold March 13 call, the issue that was brought up was the commission cost. He was told by the brokerage company that if he let it be assigned it would cost him only $15 per side, totaling $30, whereas if he just closed the Bear Call the commission would be much higher. I had no comment to make after hearing this.
In conclusion, what we should learn from Trader Joe’s extremely expensive and excruciating lesson is that we must be familiar with the product that we are trading. We must know when its earnings releases are coming up, what is the current implied volatility like (high or low), and when the dividends are being paid out. Basically, know the product that you are trading and be intimate with it. Good Trading.
- Josip Causic
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