More Position Evolution

Russ Allen

This is part 2 of an article on Position Evolution. You can read Part 1 here. In that article, I began describing an example of a transformation of one option position into another type of position, to create a position that was better fitted to changing market conditions.

Our example was from an options Pro Pick from some time ago. It was a Diagonal Spread on the real estate ETF called IYR.

The chart of IYR is reproduced here as it stood at the beginning of the trade:

Figure 1 – IYR Chart

Position Evolution

In Part 1 I described the first three entries in the log for this trade which were as follows:

~ 8/2/12, 12:52 PM (Pacific) ~

We are in using stock… We bought 980 shares @ 64.71

~ 8/2/12, 12:54 PM (Pacific) ~

Tomorrow we will evolve the position into an Option strategy… We are not doing it right now because I just got in front of my screen and the market will close in 6 minutes so the probability of a nice fill shaving the spread is low.

~ 8/3/12, 9:43 AM (Pacific) ~

Closed Stock @ 65.85 for a $1,117.20 profit and entered the pre-planned Options Trade…

If you missed last week’s description of the trade to this point, you can read it here.

At this point, we were in the trade as follows:
Long 27 December 64 call at $3.68
Short 27 September 68 calls at $.53
Net Debit per spread $3.15
Total Debit $ 8505

Here is the remainder of the log:

~ 8/29/12, 7:13 AM (Pacific) ~

 Stop is now moved below a new Demand level (64.87) that has been created as the price finally left the level…

After 26 days, the stock finally moved away from the entry area. A new demand zone was now visible, and the stop price was moved up from the $64.20 area to $64.87. Since this trade had positive Theta, we were OK with holding it for a while as it made up its mind whether to move. We were accumulating income from the faster time decay of the short September 68 calls compared to our long December 64 calls. Then, two days later:

~ 8/31/12, 7:32 AM (Pacific) ~

Closed the short unit for $0.05 for a profit of $1,296 [(0.53-0.05)*27*100]

With three weeks of life still remaining, the value of the short September 68 calls had dwindled from $.53 to $.05. Since it is our policy to close out any short option position if it drops to $.05, our limit order to Buy to Close at that price was filled. We were now left with just the 27 long 68 calls. So next, we…

~ 8/31/12, 7:41 AM (Pacific) ~

Evolved the Diagonal into a Vertical Spread by Buying 6 more of the Dec 64 Calls (Paid 2.96) and Selling 33 of the Dec 68 Calls (Received 0.98)…

Implied volatility was now a little higher than it had been, so a new strategy was called for. A Diagonal spread’s exposure to IV changes is extreme, which is why we originally chose it (IV was extremely low, and therefore very likely to rise). Now it was time for a Vertical spread, which is appropriate when IV is just moderately low. We could have simply sold 27 December 68 calls to match our 27 long December 64s. This would then have left us with 27 December 64/68 vertical call spreads. But with our revised stop, we could afford to expand the position and still keep it within our maximum risk. So we added an additional 6 December 64 calls at $ $2.96, for a total of 33; and then sold 33 December 68 calls at $.98. We now held 33 December 64/68 vertical call spreads.

The next 4 log entries describe continuing to lower our risk by raising our stop in response to continued upward price movement:

~ 9/5/12, 7:53 AM (Pacific) ~

Stop is now moved higher below the new Demand zone formed in the Daily chart…

~ 9/6/12, 7:31 AM (Pacific) ~

A new Demand level has been created. We trail stop manually right below it…

~ 9/6/12, 11:12 AM (Pacific) ~

Stop is now 65.52

 ~ 9/13/12, 7:02 AM (Pacific) ~

New Demand has been formed in the Daily Time Frame. Stop is now 65.95

On the above date, IYR topped out at $67.55, exceeding our $67.50 price target. Since our instructor couldn’t be at his computer at the time to finesse the exit from the option trade, he had an order to sell the stock short at the target. Using the net delta of the position, he calculated that 1229 shares were required to offset the option position, and entered the order. This was filled late in the day:

~ 9/14/12, 12:11 PM (Pacific) ~

Neutralized yesterday using 1229 shares @ target price (67.50)

 Now the option position was closed:

~ 9/14/12, 12:11 PM (Pacific) ~

Closed the Options today @:

64c @ 4.33

68c @ 1.60

 ~ 9/14/12, 12:13 PM (Pacific) ~


-Initial 27 64c provide a $1,755 profit (4.33-3.68)*100*27

-Later 6 64c provide a $822 profit (4.33-2.96)*100*6

-Later 33 68c provide a $2,046 loss (0.98-1.60)*100*33

 Finally, with the option position closed out, the shares used to hedge it were liquidated. Since IYR had moved up, the hedge itself showed a loss. This was fine, since they had served their function by allowing us to lock in the profit on the option position.

~ 9/14/12, 12:15 PM (Pacific) ~

Closed the shares used to neutralized for $614.5 of loss (68.00-67.50)*1229

~ 9/14/12, 12:15 PM (Pacific) ~

The net outcome of the trade is therefore: $2,329.70 (1,117.20+1,296+1,755+822-2,046-614.5)

So there we have it. A trade that started out as one thing, was expertly transformed into several separately profitable trades. At each transition, risk was contained with stops and appropriate position sizing.

As I mentioned earlier, this trade had more phases than most, by far. Few trades go through this many changes, or need to. But when the occasion arises, position evolution can help us squeeze the most out of a trade.

For questions or comments on this article, email me at rallen@tradingacademy.com.

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. Reprints allowed for private reading only, for all else, please obtain permission.