Lessons from the Pros

Multiple Scenarios of Possible Outcomes

In this article, I will present three possible exit strategies for a single trade. Although it is a single option trade, it actually involves multiple legs. At any given time, a trade can go against the trader and at no time would I allow myself to be unprepared for it. After all, trading is similar to being involved in warfare between the bulls and bears. During warfare, there must be a plan for exit strategies based on possible scenarios.

After the publication of my previous article, I have received some emails from our readers requesting that I get much more specific on the exits. In last week’s article, I was discussing a Bull Put which is essentially a vertical credit put spread. Rather than doing another article on a Bull Put, I will discuss the mirror image of it. This is a vertical credit spread called a Bear Call.

As I previously mentioned in Plan your Exit(s) Beforehand, during my planning stage I actually go through the checklist. I created that checklist awhile ago and it works quite nicely for me, so I am not planning to change it as long as it works. The saying goes, why fix something that ain’t broken. I encourage the readers to have similar checklists of their own.

Prior to doing any swing spread trade, I go through my checklist. I suggest physically printing out a piece of paper that lists the criteria which must be met during the planning stage. Figure 1 shows my checklist.

The only addition on this checklist from the one that was published in my previous article was the 5th stage. This whole article is about multiple exit strategies so it is just in this one area that I will be focusing. I will not spend, in this article, too much time on the steps 1, 3, and 4. However, I will use the charts so it can be seen why I am placing a Bearish trade.

Bear Call Example

Let me go briefly over the first four steps for planning the trade, starting with the first stage. Even though the (F.A.) Fundamental Analysis tells me what to trade, and not when to enter the trade, the F.A. still has the time component in it. On the product that I have selected, I have checked its (E.R.) earnings release date, and it was on 04-22-2009. The dividends were paid out in the amount of 0.10 on 04-07-2009 and a stock split was not on the horizon. Having checked these three F.A. things, I place a check mark on my check list next to F.A. and move on to (T.A.) Technical Analysis.

Figure 2

Figure 2 shows the daily chart of the stock that I am discussing. I have marked with the black lines a symmetrical triangle which was forming at the time of writing this article. As the price is coming to the apex of its triangle, it is just a matter of time before it will break. The earnings release did not push the stock out of the symmetrical triangle but time will. On Figure 2, I have also marked with a gray line a solid resistance around the 95 zone. This area of 95 is very essential for me and I will come back to it. Check off the T.A.

The third stage is checking the (I.V.) implied volatility. Currently the I.V. is at 67%, the highest it has been was 156%, while the low was 44%. I could do either a debit or credit. I chose to do a Bear Call which is a vertical credit spread. Checkmark I.V.

The fourth stage is the Position Sizing. I will write more in depth about this in one of my future articles. For the novice option spread traders I suggest to do a single contract. For simplicity sake, I too will use a single contract.

Finally, I am at the point of discussing the three possible scenarios. Before I do that, let me specify by making reference to Figure 2, which shows the chart of the stock on which I am placing my option trade. The blue horizontal line marks the zone of 95 which acts as a resistance, so I have placed a Bear Call by selling a 95 call and protecting myself by buying a 100 call. All that needs to happen is that the stock stays below 95. Currently, it is at 81.82. Almost 13 points away from my sold 95 call strike price. The 13 points act as the buffer zone that I have given to myself.

The stock is at 81.82 and my Bear Call is made up of these legs:

BTO + May [.16Delta] 100c @ – 1.15 (4 strike prices OTM)
STO – May [.24Delta] 95c @ + 1.90 (3 strikes OTM)
Max P = + 0.75 (Reward, credit, profit, prize, or gain)
Max L = 4.25 (Risk, Cost, Loss, or Pain)
RRR = .75/4.25 = 17% in 23 days with the weekends
BEP = (sold call strike price plus the credit received) 95c + 0.75 = 95.75

My alert is set at the amount of the reverse of BEP. Instead of adding the credit to the sold call, I subtract the amount of credit from the sold call. I set my alert at 94.25 (95 minus 0.75) and when my alerts goes off, I do not hesitate to take action.

Now, let me get to the specifics, we have three possible scenarios. The reason why there are three is because the market can only go in three directions.

Scenario 1: the stock closes below 95 and I keep the Max P

Scenario 2: it closes above 100 and I achieve Max L, if I did not act on my 94.25 alert which went off when the price was coming towards my sold 95 call.

Scenario 3: the price closing within the spread.

This is the most complex scenario to explain, for I cannot clearly say Max P or Max L. Most of the time things in life are neither black nor white – they are kind of gray. When the price closes in between our spread, then the things are in that fuzzy area and the outcome depends on where exactly the price has closed in between the strike prices.

There are also three possible variations of the third scenario. For, if it closes towards the bottom part, it would give us a more different result than if it closes near the top part, or if it closes exactly at its BEP (Break Even Point). Here are three possible variations: outcome A is at its BEP, outcome B is near the top, and outcome C near the bottom.

Outcome A shows the BEP of 95.75

Outcome B is showing us less than Max Loss. Our Max L was 4.25 and here our loss is 4.20

Outcome C = showing us a small gain. The reason for that is that our BEP was 95.75. In the case presented here, the price has closed at 9.25 giving us a 50 cents gain. Not much.

In conclusion, I have presented multiple scenarios for my trade. I am aware of every one of those scenarios beforehand. I am an option trader because by my innate nature I love to have choices. I feel that trading equities limits my choices, especially when it comes to directional trading. This trade was a spread trade which aims at profiting from time decay.

Out of all the scenarios presented, I would not allow my trade to come to the point that I have achieved Scenario 2 (Max L) or any of the outcomes of Scenario 3. My alert is set at 94.25 and when it goes off, I then go into action. Pro-active traders make more than the ones who re-act after the fact. There is no time for hesitation when the trade is clearly planned out. Once it is planned, it is so easy to follow the predetermined course of the action. Once again, plan your trade exits beforehand, and trade your plan. Good trading.

- Josip Causic