May 7, 2003

Turning Long Option Losers into Money in Your Pocket
by John Brasher, CallWriter Publisher
 

Sounds crazy, I know, but yes, it can be done. Suppose you bought call options because you expected a stock to move up, or bought put options because you expected a price drop in the stock. But you calculated wrong... the stock is either not moving or going the wrong direction.

There is another option...

Long calls and long puts are stock options that have been purchased. The long call or long put position is a debit trade, because you paid money - a net debit - to execute it. If the underlying stock moves enough in the anticipated direction, the long option becomes profitable, because as the stock price moves, the option becomes increasingly valuable and you resell it for a profit. But time is NOT on the call or put buyer's side, because the option ceases to exist at expiration, and every day the option loses a little bit of time value, which is known as time decay. So if the stock moves the wrong direction or just holds price, the long option loses and at expiration you say goodbye to the premium you paid for it. Right? Wrong. There is a technique for turning a losing long option position into a winner, and it is known as spreading the long option.

The long option doesn't have to lose under those circumstances!
Suppose you paid $0.40 for a 22.50 Call on a $20 stock. The stock's price fails to make the expected advance and even falls a bit. What do you do then? Some traders would simply watch the call expire worthless. Most traders would sell off the call, getting what they could for it. As the stock price drops, the price of the call will drop, also - in addition to the loss from time decay. Selling off the call ameliorates the loss somewhat, but still leaves you with a loss.

But is there a way to snatch a profit out of this losing trade?
Let's say the stock has dropped and your signals indicate a continuing decline. Perhaps the overall market is declining. The stock's bullish outlook has turned bearish, and your bullish long call position on the stock will lose. Here is an alternative: you keep the 22.50 Call and sell a call option with a lower strike price - in this case the 20 Call - on the underlying stock. Of course, you receive more for selling the 20 Call than you paid to buy the 22.50 Call. Selling the 20 Call does four things:

1)  puts money in your jeans, since selling the call now generates a net credit;

2)  turns the bullish long-call strategy (that is sure to lose) into a bearish spread strategy;

3)  makes time decay work in your favor, since you now want expiration to occur and lock in your profit; and

4)  turns a losing trade into a winning trade!

This new position, known as a bear call spread, will win if at expiration the stock is at or below the strike of the call you sold. So if you sold the 20 Call, the new spread trade will win if the stock is at or below $20 at expiration, because you keep the net credit generated by selling the call. Remember that time decay is now working in your favor. Don't sell a strike that is in the money, unless the stock is dropping and you are very sure of your analysis, since you will likely be called out of the short strike sold if it is in the money at expiration even a little. But selling the 20 Call in the above example might be fairly safe, since the stock already has dropped below $20. The bear call spread involves a small risk, but in the above example, the long call was a sure loser, anyway. This position is known as a bear call spread because it wins if the stock holds price or drops and thus is neutral to bearish.

If this situation happens to you, don't hesitate to sell the lower strike call and spread that long call.

What About Long Puts?
The above strategy works in reverse, also, when you've bought a put and the stock price is rising. In that event, you keep the long put and simply sell a put with a higher strike than the long put. This creates a bull put spread, it generates a net credit, turns a bearish position into a bullish one, starts time decay working in your favor and turns a losing trade into a winner. This position is known as a bull put spread because it wins if the stock holds price or rises.

Let's say you bought the 17.50 Put when the stock was $18, and the stock has now moved up to $20. This is trouble, since the put gives you the right to sell ("put") the stock to someone else at $17.50, which is not a profitable transaction when the stock is trading at $20. Your strategy in buying the put is now kaput, since it depended on the stock dropping below $17.50 in order to win. Consider selling the 20 Put for far more than you paid for the 17.50 Put. This generates a net credit to you. If you buy the 20 Put, here's what happens at expiration: if the stock is at or above $20 at expiration, your trade wins, because no holder of the 20 Put is going to exercise his put in order to sell the stock to you at $20 when the market price is higher than $20. For this reason, you cruise to expiration keeping the net credit generated by spreading the long put.

Look at the Flexibility of Spreading!
The spreading strategy frees you to buy puts and calls. We know, only 10% of stock options are ever exercised, which is an indicator that few long options win. So what? Very few people ever exercise an in-the-money option, but instead just flip (resell) the option, which yields a better profit profile than exercising the option. It is also a fact that 30% of options are settled out, meaning that the holders either buy or sell the option in order to close their short (or long) position. These facts are courtesy of CBOE.

The exact profitability of spreading long calls and puts will depend on the underlying stock's implied volatility (and therefore how fat the short strike's premium is at the time), the stock's price in relation to the option you want to sell, and the time remaining until expiration. It will not yield a worthwhile profit in every situation and, because stocks can move unpredictably, will not work in every circumstance. We also suggest some analysis of the stock to try and determine if you simply called it wrong (in which case, don't hesitate to spread the long option) or if its price action is due to impending news, earnings about to be reported, behavior of the stock's sector or similar factors. Creating a spread involves risk, and the amount of the risk is equal to the amount of the spread (difference between long and short strikes) less the net credit received. In the above examples, the risk would be $2.50 (difference between 17.50/20 and 20/22.50 strikes), less the net credit generated. However, at the point you spread the long option, you probably have more insight into the movement of the market and the underlying stock than when you bought the option originally!

Good luck and good trading!