Recently I’ve been writing about exiting an options position. I talked about stops, and also about rolling a position to more favorable strike prices and/or expirations. Today I’ll introduce the idea of position evolution, which is different from either stops or rolling.
As I described earlier, rolling a position means transforming it into a different version of itself. Examples would be rolling down a Jan 175/185 put spread into a Jan 165/175 put spread; or rolling out that same put spread into a Feb 175/185 put spread. In these cases, the resulting position is still the same type of position as the original – it both started and ended as a put spread.
By contrast, evolving a position means turning it into something else entirely. For a simple example, a covered call position (long stock plus short call) evolves by itself into a long stock position when the short call expires. A slightly more involved example would be a call calendar spread (long a long-term call and short a short-term call); when the short-term call expires, the position has evolved itself into just a long-term call. We could then sell another short-term call, thus evolving the position further into another calendar spread.
Taking this a step further, with our call calendar spread, we could have evolved it into something completely different. For example, after covering the short-term call, we could then combine the remaining long-term call with:
- Another short-term call at a different expiration and the same strike, to create another Calendar Call Spread
- A long-term call at the same expiration and a different strike, to create a Vertical Call Spread
- A call at a different strike and expiration, to create a Diagonal Call Spread
- Two additional short calls and another long call, at different strikes, to create a Call Butterfly
There are certain circumstances where evolving a position will be to our advantage. One of the main things that will lead us to this action is a change in implied volatility. Since different options strategies have different levels of exposure to a change in implied volatility (IV), it follows that we use different strategies in times of high IV (e.g. naked short calls or puts, short strangles, etc.) than in times of low IV (naked long calls or puts, diagonal spreads), and so on.
Often, we will start out with a strategy that fits our outlook as to the future underlying price, and our outlook as to future changes in IV. After some time has passed, IV may change so that a different strategy is called for. We may then be able to re-purpose a part of the existing position into a new one that better fits the current conditions.
A great example of this was in one of our Option Pro Picks from a year or so ago. In this example, one of our instructors:
- Identified a Long Call Diagonal trade opportunity
- Day 1: Entered an equivalent position using stock instead of the options (see explanation below)
- Day 2: Replaced the stock position with the planned diagonal trade, making a profit in the process
- Day 29: Evolved the diagonal into a vertical when IV changed
- Day 43: Neutralized the option position using a short stock position triggered by the underlying
- Day 44: Closed out the full position at a profit.
Not many positions involve this many steps. But this is a good example of several different kinds of position evolution.
Here’s the background. As of August 2, 2012, the real estate ETF called IYR was in a solid demand zone, so price outlook was bullish. Implied volatility was very low. Here is the chart, as it appeared in our Pro Pick for August 2:
Our instructor projected a target of $67.50, and selected a stop price just above $64.
The indicator at the bottom of the above chart is a plot of Implied Volatility (red line) vs Historical Volatility (blue line), with the previous year’s range of IV divided into segments (grey lines). Not all of the previous year is shown.
The IV reading on the chart was 18%, which was very low for this ETF. Volatility for the previous year had ranged from 10% to 52%. Our instructor chose a diagonal Call Spread, as follows:
- Long the December 2012 64 calls
- Short the September 2012 68 calls
- Quantity: 27 contracts (for a projected max loss of about $500 if our stop at $64.10 was hit)
- Net Delta of the position was about 36.3 per spread
Note that the projected loss at the stop price was calculated using an option payoff graph. There is no direct way to calculate it without one.
The Diagonal spread was chosen in this case instead of just a long call, even though the outlook was quite bullish. Turning a long call position into a diagonal spread, by selling a higher-strike, shorter-term call, adds a very desirable attribute: the position now makes money from the passage of time, instead of losing it! This is because the amount that we receive for the short 68 call more than makes up for the drop in time value of our long December 64 call.
Furthermore, we thought that an increase in implied volatility before the September expiration was likely. If that happened, then when the September 68 call expired, we would be left with our long December 64 call with two months remaining in its life. It would have then been inflated further by the increase in IV.
Here’s how the first part of the log of this trade played out. See below for an explanation of the first three entries.
~ 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 probabilities 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…
Here is the explanation for these entries:
The trade was identified early in the day on August 2, while our instructor was traveling. He was not going to be able to be at his computer for the rest of the day. With multiple contracts and two separate positions, getting a good price on all the contracts was very important. He did not want to be pressured for time, but wanted to lock the trade in. He elected to enter an equivalent stock position, which he could do very quickly, to avoid missing the rally.
To temporarily use the stock itself as a substitute for the option position, the number of shares needed to be calculated. As stated above, the net Delta per spread was about 36.3. This was a combination of +56.4 on the long December 64 call, and -20.1 on the September short 68 call. The equivalent stock position was calculated as follows:
Delta per spread: (+56.4 – 20.1) = 36.3
Number of spreads: 27
Total Delta = 36.3 * 27 = 980
To capture the approximate profit that the spread would make, without buying the spread itself, we bought 980 shares of stock. Since the IYR shares themselves trade in a very liquid manner with only a penny difference between the bid and the ask prices, we could lock in the same profit (or loss) over a short period by buying the shares. We’d want to sell the shares and put the option trade in place as soon as possible. This would then free up the substantial buying power (980 * $64.71 = $63,416) that was tied up in the stock position; it would also let us begin to benefit from positive time decay and volatility characteristics that only the option position had.
This transition was done the next day.
On the morning of August 3, the stock was sold, and the option position put in place at the prices listed above. This provided a textbook example of the benefits of position evolution. In this case, the stock opened the following morning with a substantial gap up, more than $1 per share higher than our purchase price. By temporarily using the stock position, this profit was captured, and amounted to $1117. This trade was off to a great start!
We’re over our space allotment for today. Next week we’ll describe the rest of the progress of this trade.
For comments or questions on this article, contact me at email@example.com.