OPTIONS ARTICLE

A Repair Strategy (Debits)

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Josip Causic
Instructor

In one of my most recent option classes in Overland Park, Kansas, we were working on a vertical debit spread. I have covered in these newsletters the topic of debit, as well as credit spreads in great detail. However, I have not dabbled into the repair aspect of a trade and that is exactly what Curtis, a Kansas option student, asked me to do. In order to lay out a clear and concise case, I will first start by explaining the trade and then in part two, I will proceed to an adjustment strategy.

PART ONE: Trade Layout

On the day of placing this particular vertical debit spread, EEM (Exchange Traded Fund that tracks Emerging Markets) was trading at $43.11 and looking at the chart (meaning the price action) as well as volume, which was huge, a bullish forecast was made. One of the steps involved in placing an option trade, besides doing both technical and fundamental analysis, also involves checking the I.V. (implied volatility) readings. EEM’s I.V. at that time was sitting at the lower range, but not necessarily at the lowest point it has been in the last 52 weeks. The fact that I.V. on EEM was in that lower range translates into a debit strategy. Debit means being a buyer, yet being a buyer could also be used if we were bearish using a debit put spread, which is also known as a Bear Put. Anyhow, the chart or technical analysis tells us which direction to pick and that day it turned out we needed a bullish strategy. In Figure 1, I have laid out the specifics of our Bull Call on EEM.

Action

Expiry Month

Strike Prices

ITM/ATM/ or OTM (In the money/at the money/out of the money)

BTO (buy to open)

Oct (29 days left)

+41 call

2 strikes (ITM)

STO (sell to open)

Oct (29 days left)

-44 call

(OTM)

Figure 1: Bull Call on EEM while the underlying is at $43.11

Just a quick recap what the data in Figure 1 shows. The Bull Call is composed of two legs, one purchased (Oct 41 call) and one sold (Oct 44 call). With the underlying sitting at 43.11, the long (Oct 41 call) leg is already two dollars in-the-money, which is displayed in the ITM/ATM/ or OTM column. The short (Oct 44 call) leg is out-of-the-money. More specifically, the 44 zone is where we are anticipating a level of resistance; hence, as option traders we do not expect that Oct 44 call is going to be above $44 at October expiry. If that is the case, the short leg will expire worthless, while the long one (Oct 41 call), which already was two dollars in-the-money at the entry, should be even more in-the-money. If EEM closes at $44 even, then the Oct 41 call would be a whole 3 points ITM. (As a side note, the aim of this article is to lay out the repair strategy rather than to go into the specifics of a vertical debit spread. For that, please click on the following hyperlink – Vertical Spreads: Part III.)

PART TWO: Repair, Adjustment or Follow-Up Action Required

Let us assume that at the Bull Call entry, everything looked Bullish, but afterwards, it didn’t. EEM started first going higher, and then it dropped, passing our entry point of $43.11 and going even lower. Then the question was raised: "How do we repair the Bull Call?" There are different ways to do it, depending on the specifics.

The first step, besides looking at the price action, would be to check the change in volatility. The volatility tends to be low when there is complacency in the market place, yet as fear creeps up, the volatility takes off. With EEM going lower, this would be the case.

Next, let me break down the trade into two pieces. The long leg, which was bought, has to have to an extent benefited from the increase in implied volatility. I already have paid a premium for the 41 call which was two steps ITM with a high delta and low exposure to the time component. Once again, I bought something that has, after my purchase, increased in extrinsic value. At the same time the premium has increased in value, my intrinsic value has decreased. For instance, if EEM dropped to 41, and originally was at $43 at the point of my entry, with the Oct 41 call being 2 points ITM; now at 41, the 41 call is ATM, so 2 points are gone intrinsically speaking. At the same time, though, the extrinsic value has increased due to the increase in the I.V.

Next, let us look at the short leg: The Oct 44 call was OTM when EEM was at $43.11, and now with EEM being at 41, the 44 call is even more OTM. Hence, the question: How to repair this Bull call? One of the ways would be by turning the top leg (-Oct 44 c) into a Bear Call, and the lower leg (+Oct 41 c) into a horizontal spread. Let me visually show what the whole thing would look like step-by-step.

STEP 1: Turning Oct +41/-44 Bull Call into Oct -44/+45 Bear Call

EEM $41

Sep Week D (1)

Sept Week E (7)

Original Trade

Follow-Up Action

 

 

+Oct 41 (2 x ITM) c

 

 

-Oct 44 (OTM) c

 

 

 

+45 (4 x OTM)

Figure 2

Figure 2 above shows the table with four columns. The first two are relevant for the step 2 of our adjustment, the 4th column is where the fix of the Bull Call into the Bear Call takes place. Once again, for those unsure of what and how a Bear Call works, here is the hyperlink, Vertical Spreads: Part II. In short, we keep the short 44 call intact, we simply buy a 45 call for virtually nothing. EEM is no longer at 43 but at 41, so the cost of a long 45 call (4 steps OTM) is close to 0.05, and now I have a -44/+45Bear Call, yet our long ITM 41 call has not been addressed.

STEP 2: Turning the long Oct +41call into a Horizontal (Sep Week E -41) Spread

EEM $41

Sept Week E (7)

Oct Week A

Oct Week B

Original Trade

-41 (ATM) c

 

 

+Oct 41 (2 x ITM) c

 

 

-Oct 44 (OTM) c

 

 

Figure 3

Figure 3 above addresses only the long 41 call, which is currently at-the-money (ATM) with the highest possible premium due to the increase in the IV. Moreover, EEM has weekly options listed on them which means that the October (also commonly referred to by some brokerages as Oct Week C) has the following weeks approaching before its expiry; Sep Week D, or the fourth week of September, which at that time had only one day left to expiry, so no action was taken using those options; the next one was Sep Week E, or the last week of September, with expiration Friday being actually October first; then Oct Week A; and lastly Week B. The regular October options, or week C, is the third week of October, and is the long 41 option that we already own.

The outlook for the Horizontal Trade is Bearish for the short-term for week E of Sept, as well as Oct A & B, while for the long-term, meaning the regular Oct option, the outlook is bullish. The premium received from the sale of the weeklies for the next three weeks should offset the loss of the Oct 41 premium.

To sum up, this newsletter has gone over some specifics about the vertical debit spread; namely the Bull Call. Hyperlinks were also provided so the readers could get the specifics of the other strategies in a bit more detail. Moreover, I have offered an example of an adjustment to our Bullish trade which has turned south on us. Again, I wish to emphasize the (indefinite) article "an" adjustment strategy rather than "the." Had I used a definitive article, that would mean that the vertical debit spread on EEM had only one possible choice for repair; if that was truly the case, would that not be sad? Imagine option traders NOT having many choices/options to repair the trade. Options always offer options, yet be aware of the fact that the closer to expiry the trade becomes, the less and less choice are available to option traders. Know your options, as my predecessor would say.

- Josip Causic

Disclaimer
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.