Lessons from the Pros

Powerful Lesson of a Painful Trade: Part I

This is the first of a couple of articles on the topic of how any painful trade can hold a valuable lesson.

At the end of one my classes at Irvine, an option trader stopped by for some small trading chit-chat. By the look in his eyes, I could tell that he had a large position that was eating away at his sleep as well as his finances. Without disclosing the trader’s identity, I would like to describe the situation in which the trader had found himself. He owned 10,000 shares of an unnamed pharmaceutical underlying which, at the time of his entry was trading at $9.95 ($9.95 times 10,000 equals $99,500 in a single trade). Knowing as much as he did about options, he had chosen to sell credit calls on the shares that he owned. As a reminder, each contract controls 100 shares, so if a trader has 10,000 shares (divided by 100) he could sell 100 contracts of covered calls, which is exactly what he did. The strike that he selected was $10 and the stock was trading below $10 at the time of his transaction; $9.95 to be exact. The premium he received equaled $1.10 per contract, or $1.10 times 100 contracts times another 100 since each contract controls 100 shares. The possible maximum profit on the covered calls equaled $11,000 if the stock at expiry closed below $10.  In such a scenario he would keep the shares of stock and see the sold calls expire worthless. (Many traders, including him, assume that the maximum profit is theirs to keep from the day they enter the trade. It is only after closing the trade or expiry that a trader knows how much profit he actually gets to keep, for at any given time the trader might have to give some of it back.) The recap of his position is explained visually below.

The day he came to see me was Monday afternoon of November expiry week when there were only four trading sessions left. The price of the stock had rallied on good news and he exited his long stock position at approximately $11.75 while he remained short the calls. His calls were left uncovered (naked or exposed). I instantly knew that his broker had probably placed a huge maintenance requirement on his account due to this naked position of 100 short call contracts. We pulled up the option chain together and I observed that the underlying was trading above $12 and the call which he had sold was displaying the Asking price of $2.40. The most logical solution would be to buy back his obligation by repurchasing his sold calls. Figure 2 explains the specifics of this scenario.

If one really looks at the facts soberly: he purchased the stock at $9.95 and sold it at $11.75, then it is clear that he was profitable on the stock portion of his trade. He bought the stock at $9.95 and sold it for $11.75, earning a profit of $1.80 per share.

Next, the sold call which gave an initial credit of $1.10 per contract needs to be bought back plus an additional $1.30.  The sold calls at $1.10 would be repurchased at $2.40 producing a loss of $1.30 per contract.

If the loss on the calls is subtracted from the profit on the stock, $1.80 – $1.30, this still equals a profit of $0.50 per share, which multiplied by 10,000 shares would equal the grand total profit of $5,000.  By looking at the trade from this perspective, one could see that he was indeed profitable.

Yet in his opinion that is not how things happened. He viewed it quite differently, for he believed that the premium from the sold calls of $1.10 belonged to him no matter what and giving it back in its entirety was unacceptable to him. By contrast, in reality the $1.10 per contract was never his, for it is only after expiry that the sold premium really fully belongs to the trader. The condition for the entire premium to be kept is that the sold calls expire worthless.

In his case, he did not want to pony up the additional capital of $1.30 per contract to buy back the short calls, so he searched for a solution to at least break even without taking into account the profit he already made on the sale of the stock. He shared with me that his broker, specifically someone at the trade desk, had suggested that he cover his shorts and then sell a straddle at $12.50. We observed by looking at the option chain that the $12.50 calls for November would give him a credit of $0.45 per contract while the $12.50 put would credit him $0.80. When the two premiums were added, the total credit of the two naked positions would credit him $1.25.

I right away understood that this would just prolong the pain of a bad trade. I have already written an article on that exact topic: Prolonging the Pain of a Bad Trade.

Anyhow, the logic behind this was faulty. When a short straddle is done, it is certain that the trade cannot be wrong on both ends, because one of the two sides would expire worthless while the other one would not. The seller would not be able to keep both premiums.  This next figure presents the two actions that were suggested by his broker’s trade desk.

I personally hate exposure, or nakedness in trading; hence, the first step does make sense to me.  Yet, I completely disagree with the step two suggestion that he was given. The reason is simple; step two would equal a completely new trade which would produce not just maintenance on the one side, but double maintenance! Moreover, he would not be able to keep the maximum credit, for he would have to deal with this trade at expiry when he gets assigned on either his put or on his call. The sold call means that he would have to sell the stock which he does not have, and the sold put means that he would be obliged to buy the stock. The stock could keep going above the break even of $14.75 ($12.50 strike + $1.25 premium received) or below the breakeven of $11.25 ($12.50 strike – $1.25 premium received) thus leaving him with unlimited risk.

I asked him what his original intention was, and he explained that he exited the long stock thinking he had exited the whole trade. Hence, the broker’s suggestion to perform only the first step in figure 3 makes sense, but the second suggestion of shorting a straddle does not.  Opening a new position on the same underlying would equal revenge trading which is a big no-no.

In closing, this situation teaches us several lessons:

• Know the mechanics of the instruments you are trading. 
• Watch your position sizing
• Do not let the trade control you at any given time.
• Keep an objective perspective on what is going on with your trade and with the market environment that you are in.
• Have at least two exit plans, one for profit and the other for a small loss. Exiting an existing position will fit into one of these two scenarios.
• If you find that you have made a mistake in your trade, be alert and analyze your trade in the context of the trading environment you find yourself in. 
• Exiting for a small loss is a rational, unemotional and intelligent solution. 

Have green trading for the remainder of the year.

- Josip Causic