Explore Your Options
Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the STOCKS & COMMODITIES website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C.
Tom Gentile of Optionetics
CLOSING OUT A LOSING BEAR PUT SPREAD
I set up a losing bear put spread, and the price is staying above the price of the long put side of the spread. I want to exit the trade - but if I sell the long put, will I be in danger of assignment if the price drops?
As you know, the bear put spread is created with the simultaneous purchase of a (long) put with a higher strike price and the sale of a (short) put with a lower strike price. The position will generate profits if the stock price falls below the strike price of the short put. If the stock is not moving lower and the trader wants to exit the position, the best solution is to exit the entire trade. Simply selling the long put will expose the trader to greater risk. It means that the bear put spread has been converted into a naked or uncovered short put.
For example, if the stock begins to fall, the short put will increase in value. At that point, it will have to be bought back at a higher price. If not, and the stock drops below the lower strike price, then assignment becomes a risk. So yes, selling the long put in a bear put spread leaves the trader in danger of assignment on the short put, which can result in significant losses if the stock tanks. That's why it's better to close out both sides of the spread rather than legging out one side at a time.
EXITING A TRADE ORDER EXECUTION
After a position has been placed and a trader wants to sell the option to either make a profit or get out of a losing trade, is it better to place a limit or a market order?
There are no hard and fast rules about using limit or market orders when exiting a trade. Often, it depends on the situation and the urgency of the trade. When entering orders, traders can often be selective and set a limit price. So there is generally no rush to get into position.
The exit is often a different story. If the order is placed to exit a long position at the bid price, it will probably get executed immediately, with minimal slippage. This is especially true if it is a small order that is routed electronically. On the other hand, the trader can try to place a limit order to exit a long position just above the bid price and hope the market makes a move in their favor. This can be done when there is no hurry to exit the trade and/or it's a relatively slow market.
However, in fast markets, like some of the futures markets, it can be more difficult during periods of higher volatility to set limit orders and get filled quickly. In that case, it's probably better to exit the position with a market order, get an immediate fill, and thereby protect any profits or avoid any further losses. In sum, use limit orders when the market is moving slow and you're not in a hurry. Use market orders when the market is moving fast and you feel the need to get out.
STOCK SPLIT EFFECT ON OPTIONS
Apple Computer recently split its shares. I previously owned the March 90 call options. The split was two-for-one, so what happens to my options contract?
Options contracts are adjusted for stock splits. In the case of Apple Computer [AAPL], the stock split two-for-one on Monday, February 28, 2005. The stock price was therefore cut in half, but the number of shares outstanding doubled. So if a shareholder owned 100 shares at $89 on Friday, February 25, he or she would wake up the following Monday to find that they owned 200 shares trading for $44.50. The total value of their shares remains the same.
Similarly, the options contract will also be adjusted to reflect the stock split. In the Apple example, the number of contracts doubles and the strike price is reduced by half. Therefore, if the option owner holds one March 90 call on February 25, they would thereafter own two March 45 calls.
The Apple two-for-one split is relatively easy to understand. But sometimes, splits or special dividends can be a little more difficult to compute. If there is ever a question about how the split affects the options contract, the adjustment's details can be found at the Options Clearing Corp.'s website (www.optionsclearing.com).
BEST OPTIONS FOR SYSTEM
I have developed a pretty good system that is often accurate and makes small profits, but when it's wrong, it's wrong in a big way. What type of options strategy is good at picking up small frequent winners and then protecting traders like me from the infrequent big losers? How far out should I buy- one month, three months, six months, nine months, or LEAPs?
If you are using a system that produces lots of winners but big losers when there is a false signal, then risk management is important. Focus on slightly in-the-money calls or puts with contingency orders in place in case the stock goes against you. The contingency order is a technical trigger designed to get you out of the option due to a change in the stock price. See if your broker provides this feature.
As for time, the expiration will depend on your average trading time frame. In my short-term systems, I generally don't go out farther than 60 days to expiration. However, without knowing your system's details, the timing question is difficult to answer. Consider doing paper trades with different expiration dates and see which works the best.
Originally published in the June 2005 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2005, Technical Analysis, Inc.
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