OPTIONS TALK: The Condor Has Landed
May 11, 2007
I recently analyzed two trades in this column and thought it was time for some post review. The trades were an Iron Condor on MGM Mirage (MGM:NYSE) and a Bullish Call on Apple (AAPL:NASD). In the world of trading, nothing is certain and thankfully both these trades had successful outcomes. The interesting question is what you as a trader would have done. Chart 1 shows the parameters of the original MGM trade.
Chart 1 Initial MGM Iron Condor
The expiration date shows the sold 70 call option to be in-the-money (ITM). This scenario requires action in order to avoid assignment of stock. Ideally we would like the stock to finish somewhere between the two strikes sold, 65 and 70. This would mean that all the options would expire worthless and nothing needs to be done. However, the fact that MGM opened at 71.95 on expiration meant the sold 70 Call was $1.95 ITM. If the position was left alone until close, stock assignment would result.
In this scenario, you have two alternatives:
- Exit the entire position for whatever it is worth.
- Exit out of the Calls side of the trade and leave the Puts side to expire worthless.
In the case of MGM, I chose alternative 2 for the following reasons:
- MGM would have to drop from $72 to below $65 for the sold 65 Put to be ITM. This equates to a 9.7% (72-65/65) drop in a day. A very unlikely scenario.
- No commissions are required to close out the Put side if they finish Out Of The Money (OTM), which means more profit on the trade. This becomes an issue with large positions as the saving on commission can add up to significant amounts of money.
Chart 2 shows the residual risk graph of the Put side expiring worthless. It can be seen that the Calls still need to be managed as the 70 Call is ITM.
Chart 2 MGM Residual Risk Graph
The Calls need to be closed as a Bear Call Spread, Buying to Close (BTC) on the 70 Call and Selling to Close (STC) on the 75 Call. This will be done for a net debit. At the opening price of expiration day, the calls could be closed for a 1.10 debit.
The order in which to close the trade is to exit the ITM options first. In this case its the Calls that need management. Then let the OTM options expire worthless, the Put side in this case. The key to trade management is to determine the likelihood of the OTM side expiring worthless as mentioned above.
Overall, the profit on the trade was $1.10 or $110 per contract (Initial $2.20CR - $1.10 Exit DB = $1.10CR). That equates to a 39% ($110 / $280) return over a 33 day period. Better than placing your money in a term deposit! In my next article I will write a post review on Apple Inc (AAPL:NASD) which triggered a successful exit this week.
Manage Your Risk!
Oscar Lee
Optionetics AU
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