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How You Close a Trade Can Be Just as Important as Trade Selection

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Today, I'll be recording a video segment about the best ways to close an options trade which will available soon on Zacks.com. I thought I'd revisit two "Know Your Options" articles from earlier in 2018 that deal with this same subject.

From June 14th:

Our options trade in Tesla (TSLA - Free Report) last week has performed well, leaving us with a healthy profit. Now is an appropriate time to discuss the best way to unwind the trade, preserving as much as possible of our gains, while eliminating the chances of a quick market move dealing us a loss.

You’ll recall we bought a call butterfly, betting that the shares would continue to rally on good news into this week.  Our position looks like this:

Buy 1 June 330 call @ $5.10

Sell 2 June 360 calls @ $0.90

Buy 1 June 390 call @ $0.30

Net spread price: $3.60.

As of the close on Wednesday, Tesla shares were trading $345 - aided by some good news and probably a decent amount of short covering. If the stock is still at $345 when the options expire after the close on Friday, the spread we paid $360 for will be worth $1500 – a gain of over 300%.

Our work is not quite done, however. Let’s walk through some of the possible ways we can close the trade.

First, we could simply sell our long options and buy back our shorts.

The current market prices for the options as of the close on Wednesday are:

                                Bid                          Ask

330C                      $15.30                   $16.10

360C                      $1.25                     $1.34

390C                      $0.10                     $0.17

 

So if we were simply to close the options in the open market, we would receive a credit of $12.72 – a profit of $912 for each spread we did.

Because the market on the 330C is so wide however, it makes more sense to try to execute the trade as a spread, offering the butterfly in a single trade at $13.00 or $13.10, which is likely (but not guaranteed) to be filled.  That would bring our profit to something more like $945 per spread.

At that point, we’d simply have the cash we made and no position or risk.

If we think there’s no chance Tesla will trade higher than $360 before Friday afternoon, we can wait to  let the 360C expire out of the money, earning an extra $268/spread - assuming the stock stays at $345.

If the stock goes higher, to $350 or $355, the 360 calls will still expire out of the money and our total profit will rise to between $2000 and $2500 per spread.

At this point we will still have to do a trade to be completely closed and have no position next Monday. We need to sell our in-the-money 330 call, otherwise it will be automatically exercised and we will own 100 shares of stock over the weekend.

Let’s say we wait until Friday afternoon, that the stock is trading exactly $350, and that the market on the 330C is $19.60 bid and $20.40 offer.   We could sell the 330C and collect $1960 – a nice winner. The 360 and 390 calls will be out of the money and expire worthless. It might also be a good idea to buy the two 360 Calls if they’re offered at $0.10, eliminating all risk.

But there’s a better way!

In this situation, the 330C is priced at “parity” - it’s theoretical value is exactly the amount that it’s in the money - $20. It’s delta at this point is 100. Because the market bid is only $19.60, we’d be leaving money on the table if we sell that bid.

(Admittedly, $40 is a small percentage of the profit we already made on the trade, but a good trader never intentionally leaves any money on the table.)

Instead, it makes more sense to sell 100 shares of stock at $350. This is smarter for two reasons.

First, we recognize $2000 in profit rather than $1960. (We sell the stock at $350 and when we exercise the call, we’ll be buying it back at exactly $330 – a $2000 gain.)

Second, because as the owner of an option we can choose whether to exercise it or not, we are not forced to exercise the 330C. In the unlikely (but not totally impossible) event that the stock drops below $330 in the last hour of trading, we can choose not to exercise it and instead buy back our 100 shares at a lower price in the open market, keeping the difference as additional profit.

In this case, owning the 330 call and simultaneously being short 100 shares of stock exactly replicates owing a 330 put. Ill explain why next week…

From June 21st:

You’ll recall we ended up with a long call option that was deeply in the money and had to decide how to close it. We decided that selling stock was preferable to selling the call. Part of the decision was based on the fact that the bid/ask spread in the stock was tighter than in the call – so we locked in some extra profits on the trade.

The other reason was that selling stock allowed us to decide later whether to exercise the call or not, preserving what’s known as the optionality of the position.

Let’s explain why.

If we purchase a call because we think the stock is going to rise and we are correct, the call increases in value according to its delta until it becomes so deeply in the money that it has a 100 delta and moves exactly as much as the stock in either direction. The profit/loss profile for a long 350 strike call that we paid $4 for looks like:

If we sell 100 shares of stock, we make $100 for every dollar the stock falls and lose $1 for every dollar the stock gains.  The profit/loss profile is linear and looks like this:

If we were to combine the two positions – buying a call and selling 100 shares of stock, the profit and loss profile looks like this:

You’ll notice that when a long call is combined with shorting 100 shares of stock, we profit when the stock price falls below the strike price and lose the premium paid if the price rises above the stock price.

The p/l profile of buying a put at the same strike looks like this:

They’re identical!

(I’ve done the work here, but when I used to train professional options traders, I used to require them to make these p/l diagrams on paper by hand, to drive home the concept. I highly recommend that you do the same – take a pencil and paper and make your own p/l diagrams. It will reinforce the concepts.)

Because of the mathematical relationship between calls and puts, known as “call-put parity”, there is no difference between a position in which we own a call and are short 100 shares of stock and a position in which we own a put on the same strike.

A call is a put and a put is a call, assuming they’re hedged delta neutral with shares or stock.

Our Tesla Trade

We owned a call that was in-the-money (the call had a strike of 330 and the stock was trading 350) and we wanted to close it and preserve as much of our profits as possible. We had two choices:

Sell the call for $19.60 or sell the stock at $350.

If we sell the call, we lock in $19.60 minus the premium we originally paid for the call. Our position is closed and we have no further interest in the direction of the stock.

If we instead sell the stock at $350, we lock in at least $20.00 (if the stock is above $350 at expiration, we’ll buy it for $330 when we exercise the call and sold it for $350) but it could be even more because we won’t exercise the call if it’s out-of-the-money, but we’ll still be profiting from the short stock as it declines, potentially all the way to zero in an extreme circumstance – it’s just as if we owned the put for free.

Practical Application

Understanding Call-Put Parity will allow you to enter options trades at the most advantageous prices and close trades in a way that maximizes profits and/or minimizes losses while preserving the optionality of any residual long option positions.

Before you execute a trade, use these principles to think about whether there might be a cheaper and better way to do the same thing.

 

 




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