Monday, April 13, 2009

Roll Ups

Today I wanted to highlight a few management or adjustment techniques that can be used on bear call spreads when the market is in the midst of a strong bullish move. Be forewarned, there will be some math involved so hold your head still so nothing falls out!

Suppose when the RUT was trading around 420, I entered (10) April 470-480 bear call spreads.
(I'm making these numbers up for simplicity purposes so don't worry about checking them)
Sell to Open (10) April 470 calls for $3.50 apiece
Buy to Open (10) April 480 calls for $2.00 apiece
Net Credit = $1.50
Max Reward = $1.50
Max Risk = $8.50
470 call delta = 20
480 call delta = 14

Since the delta of the 470 call is 20, that implies there is an 80% chance the RUT will not reach 470 by expiration. Put another way, my probability of profit is 80%.

By assessing the delta on both the long and short calls, we can calculate our position's net delta. The net delta is -6 per spread (20-14). Since we entered 10 spreads that would bring our net delta to -60. This implies that we make $60 per $1 drop in the RUT and lose $60 per $1 rise in the RUT.

Suppose 2 weeks later RUT has risen to 460 putting us uncomfortably close to our short call spread. Here are the current numbers:
RUT @ 460
(10) April 470 calls trading @ $5.15
(10) April 480 calls trading @ $2.15
Current unrealized loss = $1.50 (3.00 - 1.50)
April 470 call delta = 45
April 480 call delta = 30
Positions net delta = -15 x 10 = -150

If we look at the current status of our RUT bear calls, you can see we're losing $150 per spread ($1500 total), and our delta exposure has nearly tripled from -60 to -150. Now instead of merely losing $60 per $1 increase in RUT, we're losing $150. Furthermore, my probability of profit has gone from 80% to 55%. Let's consider a few actions we could take to mitigate some of our remaining risk.

1. Close the entire position:
Buy to Close (10) 470 calls @ $5.15
Sell to Close (10) 480 calls @ $2.15

Although closing the trade will lock in the $150 loss, it removes any remaining risk. I have no more $$$ at risk and obviously because I've closed the trade, my delta is at 0. Losing $150 on a credit spread originally risking $850 is actually not that bad and takes the chances of a catastrophic loss off the table.

2. Close a portion (such as 1/2) of the spreads.
Buy to Close (5) 470 calls @ $5.15
Sell to Close (5) 480 calls @ $2.15

What has closing 1/2 of the trade done to my risk? It's cut it in half. My delta exposure has gone from -150 to -75. Although holding a position with -150 of delta may have been outside of my comfort zone, -75 may be acceptable. Obviously we would only want to hold on to the remaining 5 bear call spreads if we think the RUT had a chance of remaining below 470. If you're all out bullish on the RUT, then simply close ALL of your 470-480 bear spreads.

3. Roll up
Given the huge run up in the RUT, let's assume we no longer believe it will stay beneath 470-480, but we do think it may stay beneath 490. We roll up our 470-480 call spreads to 490-500 call spreads. Let's analyze the numbers.

Buy to Close (10) 470 April calls for $5.15
Sell to Close (10) 480 April calls for $2.15
This will lock in a $1500 loss
470 April call delta = 45
480 April call delta = 30
Prob of profit = 55%
Net Delta = -15 x 10 = -150

Sell to Open (10) 490 April calls for $3.00
Buy to Open (10) 500 April calls for $1.50
$150 net credit x 10 = $1500 net credit
490 call delta = 20
500 call delta = 14
Prob of Profit = 80%
Net Delta = -6 x 10 = -60

By rolling up the spread to 490-500, I have gained the following 3 advantages:
1. Increased my probability of profit to from 55% to 80%, as now the stock need merely to stay beneath 490 (not 470).
2. Lowered my delta exposure from -150 to -60.
3. Put myself in a position to potentially make back $150 (x10) of the loss from closing the original trade.

What's the trade-off to rolling up?

The biggest trade-off to rolling up vs. maintaining the original position is I can't make as much money. Remember the original 470-480 call spread had $3.00 of credit left. The 490-500 only had $1.50. However, at this point in the trade trying to eke out a profit should be the least of my worries. My biggest priority is to reduce the remaining risk in the trade and avoid a huge loss. Rolling up does both. My delta risk is reduced and my probability of profit is drastically increased, thereby drastically decreasing my probability of a huge loss.

The only times I've really regretted rolling up are when the stock continues to rise, resulting in a loss on not only the first call spread, but also the second. This is akin to adding salt to the wound or insult to injury. Consequently, rolling up should only be used if you're outlook is still somewhat neutral to bearish. If the maket is that bullish, don't fight the trend - simply do something bullish.


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