Short naked put vs. short put vertical spread, open for discussion.

Posted by: Admin: "The Vol_Trader"  //  Category: Trade strategy

Today, I’m going to try a new format. 

I received an email from a reader that I wrote a relatively quick response to. 

What I am going to do/try is to post his question here and my response and open the comments up to discussion.  Please participate….  – Lawrence

PS: I’ll post a continuation to the OTEX (losing) earnings trade later too…

Note: the reader’s name has been changed for privacy, it was not Elwood Blues writing…

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08/23/2010 Elwood Blues sent in via email:

Hi there,

I am trading mainly stock options and usually short sell out-of-the-money puts. The strategy is doing fine, but I am currently thinking about my risk management:

- Usually I follow the double out rule (i. e. as soon as an option reaches the double premium I got for it, I close it to limit my losses). But this rule kills you in a volatility spike – you are stopped out, even if the stock is still far out of the money, sometimes even moving in the correct direction.

- A friend of mine advised me to look only at the intrinsic value. This of course protects me from being caught in volatility spikes, but the losses are much higher.

Do you have any good idea?

Best regards,

Elwood

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8/23/2010 Lawrence “VolTrader” wrote via email:

Hi Elwood, to answer your question completely would require a pretty long options education, rather than just an answer but I will do my best to give you a simple explanation…

You are right when the underlying moves against you the vol spike will increase losses.  This works in your favor as the market goes up, vol goes down and your short put benefits, a double edged sword.

A simple fix to this is to sell a put spread instead of a naked put.  This means sell your OTM put and buy a further OTM put as protection.  This limits your losses, reduces your margin requirement and protects against vol spikes.  As your short put gains in value due to the underlying going down (delta effect) and gains in value due to vol increase (vega effect) your long further OTM put also gains in value due to delta and vega…  Also, because these are limited risk (not unlimited like short naked put) you can hold them longer and see if your underlying moves back in the favorable direction and allow time decay (theta effect) to work in your favor as both options lose value over time, the closer to the money short put faster.

Elwood, can I post this conversation to my blog and open it up to discussion through comments?  (I’ll just put a fake name for you)

Lawrence

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08/23/2010 Elwood Blues sent in via email:

Thanks a lot for your quick reply! I thought about this strategy as well – the minus is only that it will also limit my possible profits…

Sure you can put it to the blog!

Regards,

Elwood

UPDATE OTEX trade management after earnings release

Posted by: Admin: "The Vol_Trader"  //  Category: Earnings Trades, Trade Management

If you have not already, please read my guest post at Option Pit (Click here) prior to reading this post.

So, OTEX reported, “profit up on higher revenue and cost cuts”.  Premarket the shares are up from their close of $37.25 to $41.  See chart below: (click any picture to enlarge)

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At $41 our trade is suffering the max loss I predicted yesterday to the upside as of this writing premarket.  (See P&L plot below) When the market opens I’ll look to close my short puts first and then see if there’s any decrease in underlying price as I think today should be a down day with the terrible jobs numbers…

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UPDATE: 09:31  Ok, so the market now is open and OTEX is up around $43.80.  I bought back my short $35 Sep puts for $0.10 for a nice profit.  Now I will watch to see the price action of OTEX.  I predict it will hit it’s highs at the open and spend the rest of the day retracing it’s gains. 

UPDATE: 09:51  As predicted OTEX hit it’s high If it makes a new high on the opening 5 minute bar and has come down some.  I’ll continue to monitor now.  The 5 minute chart and current P&L plot after the short put was closed are below.

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I will continue this post later today, stay tuned.

V – update – trade management, a favorable roll

Posted by: Admin: "The Vol_Trader"  //  Category: Volatility Trades

As you know from my previous post and update on the V trade (Click here to see), we’ve taken off 3 of the 10 contracts for a profit. 

Since then, the underlying has moved up and away from our profit zone.  (Trade was entered with V at $74.20 on 5/21/2010 and moved as high as $77.49 on 6/10/2010.

Yesterday I rolled the remaining 7 short Jun $65 puts up and out to the Jul $70 puts for a credit of $1.67 (Bought back the Jun $65 puts for $0.07 and sold the Jul $70 puts for $1.60). This moves my upside breakeven price up to around $72.95 at current IV’s.  V is currently trading above that at $74.64 as I write.

Below is the current Thinkorswim analyze tab after the roll. (Click to enlarge)

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As when I initiated the trade, I’ll keep $80ish as my mental stop.

This is a good example of a favorable roll at expiration week.  I was able to buy back my short puts for $0.07 and stay in this trade a bit longer.  Since I’m long the Sep expiry, theoretically, I can roll to short August puts as well in the future.  Had I lost faith in my bearish opinion on V, I would have taken the loss and closed the trade.  I’m still convinced that there is downside potential here.  By performing this roll, I stay in the trade.  By moving the short strike up by $5, I’m able to increase my chance of profiting as well compared to rolling to the same $65 Jul strike.