Directional Trade Management for Options
When used for directionally trading in the market, options offer excellent position management and risk control capabilities. A long position in a call or put option has an absolute maximum risk equal to the option's cost plus commissions, but this isn't all there is to it. Just that alone is incredibly helpful. However, while holding an option position, there are a few simple things one can do to optimize return while limiting risk, and that's what this article is about.
Move Up and Down
A trailing stop is a common strategy among traders that allows them to adjust their protected exit as the market moves in their favor. Profits can be locked in using this method. Trading options, as opposed to the underlying, allows one to achieve the same goal. To achieve this, one can use call options for long positions and put options for short positions, and the difference between the two is the strike price.
The author's own trade provides a recent example.
At about 21.50, I bought some March 22.50 call options to start a long position in Seagate Technology (STX). They cost $0.80 when bought. Over the following several weeks, the market rose sharply, finally surpassing $24. By selling the 22.50 March calls at $2.60 and buying the 25 March calls at $1.40, a roll-up was executed at that point. There were two goals achieved by this move. The first is that it removed $1.20 from the equation, which decreased the portfolio's exposure and released funds for other uses. With the $2.60 sales price less the $0.80 buy price of the 22.50 calls and the $1.40 buy price of the new 25 calls, it locked in a profit of $0.40. Meanwhile, it didn't impact the trade's remaining upward potential in any way. If the price of STX shares were to continue to rise, the two strikes would likely reap roughly equal benefits.
Another option would have been to sell the 22.50 March calls and roll all the money into the 25th March contracts if the portfolio exposure was considered acceptable at $2.60. For a ten-option position, selling the 22.50s would result in a $2,600 profit. With that amount, you could have bought 18 out of the 25 calls ($2600/$140= 18.57). Doing so actually raises the trade's potential profit margin. That being said, the entire $2600 invested is theoretically at risk, which is a larger loss than what may have been incurred when the deal was initially started.
Continue onward
Options' short time frame for holding trades is one of their drawbacks. For traders with an eye on the intermediate to longer term, this can be a significant challenge. Still, one can extend the holding time of a position by rolling forward the expiration month, much as the roll up/down.
Looking ahead, we can examine the STX case. Changing the contract from March to June would do that. The current prices for the March 25s are $2.40 and the June 25s are $3.60. But therein lies the catch. The longer the period to expiration, the more expensive the June contract is. For that reason, a roll up/down is usually the way to go when rolling ahead.
Think of the way STX rolled up from the 22.50 call to the 25 call earlier. To move forward and up, we could skip to the call on June 25 if we were still in the former. The 22.50 option is now trading at $4.10. We could complete the roll up and roll forward while removing $0.50 from the table if the 25th of June was priced at $3.60. That doesn't quite match the roll up's output, but it adds three months to our potential tenure in the role. The expected holding time for the deal determines if that is worthwhile to trade.
Expiration and the rolling of strike prices are both simply managed. Over the past few years, independent traders have seen a dramatic decline in the transaction costs associated with options trades. It paves the way for a plethora of opportunities for directionally playing the market and effectively managing holdings.
