BACK TO BASICS: Plan the Exit and Exit the Plan
April 28, 2003
When do you exit a trade? Often times, it makes sense to have an exit strategy before implementing the strategy. Of course, many traders are familiar with the “stop-loss,” which is a predetermined point in time when the trader exits a losing trade. But what about a successful trade? At what point does the option strategist determine that enough is enough and it’s time to exit a profitable trade? Well, the answer will vary based on the specific strategy, the time left until expiration, and the outlook for the underlying stock, but there are usually some general guidelines to follow and by understanding them ahead of time, it can help the strategist determine when to exit the position.
In order to understand exit strategies, let us consider an example using a strategy known as a bull call spread. In this type of spread, the strategist is simultaneously buying and selling calls, on the same stock, with the same expiration dates. The only difference between the calls purchased and those sold is the strike prices. For instance, assume that shares of XYZ corporation and XYZ options are trading at the following prices during the month of January:
XYZ stock price: $53.00
XYZ June 55 Call: $3.00
XYZ June 65 Call: $1.00
To set up the bull call spread, the strategist can simultaneously buy the June 55 call and sell the June 65 call. If so, the trade costs $2.00 per spread ($3.00 to buy the June 55 calls minus $1.00 received for the sale of the June 65 call). So the trade is done for a debit. Bull call spreads are always done for a debit—i.e. they always cost you money—because the premium received for the sale of the option with the higher strike price is not enough to offset the cost for purchase of the option with the lower strike price. In short, in a bull call spread, the strategist is buying an option and also selling a cheaper option with a higher strike price. (Note: for simplicity, commissions have been omitted but would add to the cost of the trade in real world trading.)
The bull call spread makes money if the underlying asset moves higher—hence the name “bull” call spread. In the example, if XYZ remains under $55.00 a share, both calls are worthless at expiration. In that case, the premium received for selling the June 65 call remains in the account, but the premium paid for selling the June 55 call is lost. Therefore, the maximum loss is equal to the cost of the trade, or $2.00 per spread.
In order to avoid the maximum loss, the strategist might want to exit the position before expiration if the stock does not move above $55.00 a share. Since the rate of time decay is the greatest during the last thirty day’s of an option’s life, it makes sense to move out of the unsuccessful bull call spread (or move into one with more time until expiration) at least thirty days before expiration. In this case, that would mean exiting the position some time before May option expiration. At that point, you are just trying to salvage any remaining value out of the long call and the short-call will probably have little value.
Plotting a risk curve of the trade can help the strategist see how much value will be left in the spread prior to expiration and help determine the best exit strategy in the event that the stock remains below the lower strike price. At some point, the strategist will want to exit the trade if the stock does not move in the desired direction. More aggressive traders might close the trade within a few days if the underlying stock does not move in the desired direction. Others might want to use bull call spreads using Long-term Equity Anticipation Securities [LEAPS] and give the stock more time to move higher. Nevertheless, you will want to close both parts of the spread so that you are not simply short a call. That is, you want to sell to close the June 55 call and buy to close the June 65 call to completely exit the position.
What if the underlying does move higher and the position begins yielding favorable results? If XYZ moves between the two strike prices, the strategist will be forced into a more difficult decision. The breakeven is $57.00 a share. At that price, when the options expire, the June 55 call is $2.00 in-the-money and the short call is worthless. So, at expiration, the strategist recovers the total cost of the trade ($2.00 per spread). If the XYZ is in between the two strike prices with thirty days or less left until expiration, the strategist might want to exit the trade or move into a spread with more time left until expiration. In other words, it might be time to take any profits, or eat any losses, as expiration approaches because an adverse move in the stock during the last thirty days can wipe out any remaining value left in the bull call spread.
If XYZ moves sharply higher as expected and moves above the higher of the two strike prices ($65.00 a share), the strategist will want to begin thinking about taking profits. The maximum gain from the bull call spread is the difference between the two strike prices minus the debit. In this case, $8.00 per spread (or 65 – 55 – 2). The maximum gain will occur when the underlying stock is above the higher of the two strike prices and the time value drops to zero. For example, if the options are held through expiration, the short call will be assigned at $65.00 a share and the long call will be exercised at $55.00 a share. The strategist keeps the difference between the two strike prices. In most cases, however, it doesn’t make sense to try to achieve the maximum gain. Instead, once the stock is above $65.00 a share, the strategist can exit the bull call spread and take profits.
Instead of focusing on the value of the underlying asset, some strategists set percentage return targets in order to determine the best exit strategy. For example, if the bull call spread is showing a 50% profit or a 50% loss, the strategist will exit the trade. In the example, if the underlying asset moves higher and the spread is worth $3.00, the strategist will exit the position and pocket $1.00, or 50%, per spread. However, if the underlying asset stays the same or moves lower, and the value of the spread drops to $1.00, the strategist takes the loss.
Another approach is to set up a bull call spread by using two spreads instead of one. The idea is that the profits on one spread will pay for the other. For example, instead of buying one spread, the strategist buys two spreads for $2.00 each. Then, XYZ moves up to $60.00 a share by March, the 55 call is worth $8.00 and the 65 call is worth $2.00. The spread has increased to $6.00. The strategist then takes the profits from one spread (which is $4.00) and that is enough to cover the cost of the initial trade. The other bull call spread has become a free trade.
Frederic Ruffy
Senior Writer & Index Strategist
Optionetics.com ~ Your Options Education Site
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