Tuesday, March 30, 2010

Adjusting in Action: Long Call to Call Spread

Last week's Adjustment Thinking and Salvation Syndrome post outlined some of the basic objectives of adjusting option positions. The two primary objectives were locking in gains or lowering the overall position cost and reducing or shifting risk. Since stock prices rarely move straight up or down in an orderly manner, those who maintain flexibility in their approach have an edge in producing long term profitability. As an aside, though the last sentence reflects the conventional wisdom I've subscribed to, the bullish run experienced over the last year certainly makes me give buy and hold a second thought.

Let's explore one such adjustment idea using call options on MEE (Massey Energy Corp). Suppose you decided to take advantage of the pullback that occurred in MEE from March 18-22 by purchasing a May 50 call for $4.00 on March 23rd. The net debit and max risk would be $4, the max reward unlimited, and the expiration break even $54.

As of yesterday, MEE had rallied roughly 8% and the call had increased in value to $6.70. Rather than selling the call option to capture the $2.70 gain, we may have considered rolling to a call spread by selling the May 55 call for $4.00. Since the premium received from the short May 55 call was sufficient to pay for the long May 50 call, our net debit and max risk was reduced from $4 to zero. The upside profit potential is also now capped at $500.

[Source: MachTrader]

By rolling our long call position to a call spread we've succeeded in lowering the overall position cost and reducing the risk. Due to the large rise in MEE stock, we were able to completely eliminate the potential risk in the trade. Keep in mind this will not always be the case. Oftentimes you'll be selling the higher strike call for less than what you purchased the original call. In the case of MEE, suppose we sold May 55 call for $3 instead of $4. Instead of reducing the risk from $4 to zero, it would have been reduced from $4 to $1.

Being able to roll a profitable long call to a small or no risk call spread assumes you first have the ability to turn a profit with a simple long call option- a feat easier said than done. If you are a trader that purchases straight call options from time to time, it may be worthwhile to consider adding the adjustment to a call spread into your trading plan.


Andrea said...

The approach that you have used and explained in this article is worth noticing. I am thankful to you for sharing the whole experience and explaining it in such a good way.
trading options

Prem Reddy said...

How do you close this trade?
Appreciate you help