How NOT to Fix a Short Vertical

Posted December 8th, 2011 by Josip Causic in Education

How NOT to Fix a Short Vertical

Sometimes it appears that a short vertical call could be fixed by going long the stock. This article is going to examine both advantages and disadvantages of this fix. By the end of this article, a trader will see that it may be better to use an alert and apply technical analysis to the underlying and decide if it is just time to simply close the spread rather than attempting to repair it with a long stock purchase.

For instance, if the QQQ is trading at 58, and technically it appears to be creating a double top, a trader might select a Bear Call spread as the correct strategy. The trader's bias is bearish due to the high probability of the double top play. In other words, price action frequently fails to break on the first attempt through the level of resistance, in the case of the QQQ at 58. Assuming that the trader has placed a Bear Call in which the 58 at-the-money (ATM) leg was sold and the 59 out-of-the-money (OTM) call was bought for protection, the risk is limited so there probably will not be the occasion to need to fix. The trader's outlook is bearish and the forecast predicts the QQQ price action closing below the 58 strike price at expiration.

Let us assume that for the first several days the trader's forecast is dead-on and the price is trading below 58, creating a bunch of doji (sideways) action, and then all of a sudden, huge value kicks in and a rally takes place. The short vertical, which was sold for a small credit, would now cost so much more to be bought back due to the price of the underlying being inside the spread, somewhere between 58 and 59. In this case, the short leg is in-the-money (ITM) while the long leg is just approaching the point of being near-the-money or ATM. A trader, at that point, could select to buy 100 shares of the stock to hedge the position.

The trader's reason for going long the QQQ above 58 is that the QQQ is no longer bearish but bullish, and if expiry comes, then the long 100 shares would cover the sold call contract of the 58 leg. After these cancel each other out, he could, assuming that the QQQ is well above 59, exercise his right to purchase the QQQ at 59 with his long call.

This is faulty thinking. If the price action lifts and stays above 58, then that means that the double top on the 58 area has failed. The bearish vertical spread should be all together exited and then a new bullish trade could be initiated rather than leaving a bearish option trade on while placing the long bullish bet on the stock. The key point to remember here is that fixing a losing trade can only be done by placing a winning trade ñ period. Sometimes it is better just to close the losing trade rather than try to fix it. If the price action is above the sold strike price of 58, it is probably not best to buy the stock, but just get out of the spread for a loss.

Keep in mind that a loss can be quantified in two categories: The maximum loss which is known to the spread trader from the moment of entry, and any amount lesser than the max loss. Hence, the choices to the trader are: Take a partial loss or a max loss. Also, keep in mind that many times the price action could touch the 58 sold leg and even temporarily trade above it, but not for long, and then pull back below 58. Hence, the decision for closing the spread should be made after technical analysis has been done.

In order to have the time for technical analysis before actually closing the spread, we suggest the use of alerts. When the QQQ trades at or above 58, an email, phone or text message is sent to the trader automatically from the trading platform. Having the alert instead of a blind conditional order could be better. A conditional order would specify that when the QQQ is trading at or above 58, to simply close the spread at whatever the market price is at the time. In such case, both legs are exited and two commissions are paid. The transaction debits the trader's account and the overall trade is closed for a loss which is calculated by subtracting the credit received in the initial spread from the debit paid when closing the spread. The conditional order (called contingent in some platforms) would only be preferred, however, if the trader will be on a plane or in a meeting or otherwise away from his trading platform for too long to be able to act upon any alert received.

In conclusion, rather than trying to fix a credit spread with stock, it may be better to have an alert on than a blind conditional order. Then a trader would have the necessary time for proper technical analysis before deciding to close a losing vertical credit spread. Too many times, the price action could go up to the short strike level, take out your spread with the conditional order, and then just go back down right after. We are trying to avoid getting knocked out by this action. Besides, a vertical credit spread has quantifiable, limited risk.

- Josip Causic