Watching the gains from a winning trade evaporate and turn into a loss is one the worst situations a trader can face. It sends them on an emotional roller coaster; with a sense of victory as the profits build, but a feeling of defeat when the profit slips away.
Staying flexible and adapting to changing market conditions often makes the difference between winning and losing. It’s much easier to let a position run, but a winning trade can be held too long, only to see the market reverse and erase hard-earned profits and saddle you with a loss. Fortunately, with options, a variety of adjustments are available to the creative thinker. One adjustment involves converting a winning call option into a bull call spread.
Buying call options is a simple and widely used strategy. If, for example, a trader expects the stock market to move higher, the strategist might buy March calls on the S&P 500 futures. Each call gives the owner the right to buy the S&P 500 futures at a specific price until the options expire in March. In this example, the trader is bullish the S&Ps in early November. With the futures sitting near 1,415, he buys one March 1450 call for $16.50, which is a total of $4,150 (16.5 x $250).
As expected, the S&P 500 moved higher shortly after the position is initiated. In fact, the market is building momentum and moving faster than expected. By mid December, the index was approaching 1,440 and the March 1450 call was bid at $25.00. The trader would have been quite pleased with a paper profit of $2,100 but faces an important decision. The trade is working well because the market has moved faster than anticipated. However, if the trader thinks stocks will perform even better the first two months of the year he would want to protect his winnings, but would also want to participate if stocks continue to rally. Scaling out of the trade isn’t possible because the position includes only one contract. Instead, the trader decides an adjustment is in order and sells a call option with a higher strike price.
Expecting a move above 1,475 by the end of February and before the March contract expires, on Dec. 15, with the index near 1,440, he sells one March 1475 call for $15.00.
The result of the adjustment is that the trader now owns a vertical or bull call spread that has very limited risk and considerable upside potential. The low risk is due to the premium received for selling the 1475 call almost pays for the entire cost of the 1450 call. The worst-case scenario is for the index to close below 1,450 at expiration. In that case, both options expire worthless and the net premium ($16.50 - $15.00 x 250 = $375) is lost. The risk to the spread is now $375.00, compared to the initial trade, which was $4,150.
However, the upside remains considerable. If, for example, the index expires at 1,475, the short call (with the higher strike price) will expire worthless, but the initial call will be worth $25.00 and the trade will net a profit of $5,875. At that level, the profit is considerably higher than the paper profit of $2,100 on Dec. 19. “Let it ride,” shows the risk-reward of the adjusted position.
The trader is not limited to selling the 1475 call, a relatively aggressive vertical spread. Options with lower strike prices can be used to lock in a profit and participate in a continuing rally. The formula for computing the profit potential of any bull call spread is: [(the difference between the strike prices) multiplied by the multiplier (250 for the S&P) minus the cost of the trade (debit), or plus any credit.] In our example, it equals (1,475 – 1,450) x 250 – 375.00 = $5,875.
Watching a profitable trade reverse is painful, yet traders are taught to let winners run and not be too quick to book a profit. One alternative to exiting a winning trade prematurely is to make an adjustment that can lower the risk profile of the trade and allow for further gains if the market continues moving in the desired direction. Converting a long call to a bull call spread can accomplish both goals.
Frederic Ruffy is senior writer and trading strategist for Optionetics. He can be reached on his message board at www.optionetics.com.
