Tuesday, August 24, 2010

Rolls... Fresh Out the Oven

Owning profitable positions always presents a dilemma of sorts. When things are going your way, do you double down and press the issue or ease off the gas a bit and exercise caution? In the past I've continually touched on the fortes of adjusting a position to reduce risk and potentially lock in gains. This provides a palatable alternative to those desiring to proceed with caution yet not wanting to completely close their position. Utilizing the bear playbook highlighted in yesterday's post, let's highlight one such example.

Suppose after the SPY broke below the 50 MA earlier this month you decided to up the ante on the bear side by actively seeking out low risk high reward trade setups. The retracement that occurred from 8/16 to 8/18 presented just such an opportunity. Let's say we purchased two Oct. 110 puts for $4.91 ($9.82 total) to exploit the anticipated sell-off. Given the recent bearish extravaganza, the put options have increased in value to $6.65 yielding a tidy $1.74 profit ($3.48 total). Consider the current status of our position illustrated below (click image to enlarge):

[Source: MachTrader]

Rather than staying the course or increasing our bets, suppose we take this morning's bloodbath as an opportunity to lighten up a bit by rolling our long puts into put spreads. We could sell two Oct 105 puts for $4.02 ($8.04 total) effectively morphing our position into a long put spread. Consider the updated position taking note of the overall change in risk and reward:

Though we've cutoff our unlimited profit potential, we still have the ability to double our current profits. We've also succeeded in dropping our risk capital from $982 to $178. Those actively playing with puts would be well served by familiarizing themselves with the advantages or rolling to spreads.

On a side note, the current surge we're experiencing in volatility maybe close to setting itself up for yet another fade.

For related posts, readers can check out:
Rollin with My Puts
Hedging with Calendars
Adjustment Thinking and the Salvation Syndrome

1 comment:


Excellent view on the markets moves.