Options

# Powerful Lesson of a Painful Trade

Part 1

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. The illustration below explains the specifics of this scenario as shown in Figure 2

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 and I have previously written an article on that exact topic.

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.  Figure 3 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.

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.

Exiting for a small loss is a rational, unemotional and intelligent solution.

Powerful Lesson of a Painful Trade Part 2

As a quick review, our option trader from Part 1 of this article had exited his long stock position while leaving a short call completely naked. The broker had suggested buying back the obligation and then selling a naked straddle to make up for the loss on the short calls. This is incorrect logic, for this brings exposure, or nakedness in options trading. Loyal readers know that I am always beating the drum for hedged positions.

As I presented this to him, he replied full of certainty that the underlying at this point, Monday before the expiry, would NOT go down below \$10. The way in which he articulated these words made it clear to me that his opinions about what the market MUST do, are the same opinions which had brought him into this unfortunate situation.

I believe that there are basically two types of errors that a trader can make: A Decision Trading Error and a Data Error. The latter one simply means that, because of platform or some other mechanical failure, the trader at the moment of entry doesn’t have sufficient data to make a correct decision. But in the first type of error, the trader has all the available data present at the time of entry, yet they fail to interpret the data accurately. It was clear that this trader had made a Decision Trading Error and that there was no Data Error. Being so strongly opinionated often works against the trader.

Below is the chart of the unnamed pharmaceutical stock. Observe the markings on the chart. The yellow rectangle is the Friday of expiry as shown:

In closing, this is what really happened to the trade. The following is an excerpt from his email to me, after the expiry. Some of the parts of the email were omitted so the trader and the underlying could remain anonymous.

"? thanks for taking the time to share your thoughts on how to could get out of the mess I created with the stock. You may recall that I had sold Calls with a Strike of 10.00 and the stock was currently selling at about 11.30. I had owned 10,000 shares but sold them so I was in a position where in a couple days I would have to buy them back at maybe 11.30 and sell them for 10.00. What I wound up doing was buying the Calls back at 1.10.

However, as luck would have it, the company announced either late Thursday or first thing Friday that they were going to sell 5 million shares at the price of 9.75. The stock tanked and closed at 9.53. As it turns out, I would have been fine had I done nothing. However, that’s the way the market works. Thanks so much for your help."

In conclusion, this article has presented two different endings to a trade; one hypothetical and the other factual. The point is that even if money is lost on the trade, the powerful lessons that could be learned from it should not be lost. Watch your position sizing and do not let the trade control you at any given time. Stick to your rules and be open-minded to adjust to the trading environment that you find yourself in.

##### Josip Causic

Josip Causic is an Options Instructor for Online Trading Academy. Early on in his trading career he realized that market psychology is a major part of trading so he invested heavily in workshops. At first his trading style revolved around the CANSLIM method. Later on after his encounter with former market makers, he merged his retail trading experience with the methods used by floor traders.

Josip Causic is an Options Instructor for Online Trading Academy. Early on in his trading career he realized that market psychology is a major part of...

#### stephenmatty

##### Newbie
2 0
oh i read it ,it was nice ..thanks : )

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