When a position is in your portfolio, your decision is not limited to holding and liquidation; Perhaps an options overlay or other adjustment is warranted.
Editor’s note: The "On/Off Ramp" is a four-part guide to trade entry, exit, and what happens in between. Part 1 introduced the series and looked at the trade entry process, and Part 2 was about how to navigate the holding period.
The amount of time a position remains in your portfolio depends upon your objectives. Sometimes it takes days or weeks for a strategy to play out. Sometimes you might choose to close a position the very same day you entered it. Some items in your portfolio are meant to be bequeathed to your grandchildren.
But the decision process is not limited to holding or exiting a trade when the time comes; you may also choose to make adjustments to your trade. Ideas include selling a covered call to potentially generate income from a long stock position, or purchasing a put to potentially limit downside risk. Or, if your initial trade was to open an options position, depending upon how the market fluctuates prior to the option’s expiration, you may choose to trade additional options to overlay your current position, or even swap your current position with an alternative.
Why would you ever consider making an adjustment? Isn’t it simpler to just close the trade? There certainly are times when the best decision is simply to close your trade. For example, suppose you had taken a long position in a call option, and your objective was met, and the reasons that motivated your trade entry no longer apply, there may be no reason to hang around. But sometimes adjustments do make sense; possible objectives include lowering the risk of a position and, in the case of positions with expiration dates, giving yourself more time.
In the previous installment of the series, we used the example of a long position taken in the XYZ 13 call at a price of $2. Let’s say that one week later you’re still bullish and the option chain looks like this:
You could sell your XYZ 13 call to close at $2.65 and lock in a $0.65 gain, minus transaction costs. But if you’re still bullish on XYZ, there may be no need to leave the party so early. One adjustment could be to sell the 13-15 call spread, which would close your position in the 13 call at the $2.65 bid, and open a long position in the 15 call at the offer of $1.50, or a $1.15 credit for the spread, minus transaction costs. Some traders would view this as having lowered your initial risk from $2 to $0.85 while keeping your bullish outlook. Others would say you are essentially reinvesting a portion of your profit on the 13 call into a position that keeps your initial objective intact.
Another idea from the example above could be to keep the 13 call position open, and sell the 14 call at the bid of $2. This essentially locks in the 13-14 call spread at an amount equal to initial outlay of $2. Some traders would say you own for zero, minus transaction costs, a call spread that, if both options were to expire in-the-money, would be worth $1. Of course, if both strikes finish out of the money, you would lose the entire $2 investment, plus transaction costs.
When trading options, or adding an options overlay to an existing position, the choices of strikes and expiration dates are many. But it is important to note that options trading can have significant risk, and choosing among strikes and expiration dates involves balancing risk and reward.
So now that we have explored the trade entry and ideas for monitoring and possibly making adjustments to a position, in the final installment of the “On/Off Ramp” series we will explore the exit of a position—how to determine and what to do when it is time to say goodbye.
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The covered call
strategy can limit the upside potential of the underlying stock position, as
the stock would likely be called away in the event of substantial stock price
increase. Additionally, any downside protection provided to the related stock
position is limited to the premium received. (Short options can be assigned at
any time up to expiration regardless of the in-the-money amount.)
With the protective put strategy, while the long put provides some temporary protection from a decline in the price of the corresponding stock, this does involve risking the entire cost of the put position. Should the long put position expire worthless, the entire cost of the put position would be lost.
Spreads, Straddles, and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. These are advanced option strategies and often involve greater risk, and more complex risk, than basic options trades.
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.
The information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
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