So you have a loser,
but don’t want to close it out. Maybe it’s a
complex trade like an iron condor. Or maybe it’s a single long option. Or maybe it’s just
stock. What can you do? First, don’t panic.
Cooler heads prevail. Second, if you’re
going to “fix” your trade, don’t wait until
there’s nothing left to fix.
When is losing too much, well, too much?
Many traders follow a quick rule of thumb:
cut your losses if the trade loses half or
more of its original risk. But that may not be
a good fit for all strategies.
Before fixing a trade, you need to un-
derstand that you’re not really “fixing”
anything. The loss is real, and any sort of fix
is really a new trade. So, the better question
becomes, “Does my original analysis still
hold, and would it be better to adjust my
position or exit the trade and move on?”
Consider four common scenarios and
potential ways to fix ’em.
The situation: If you bought stock at
the wrong time, it might be the right time to
introduce yourself to the short call option. By
selling a call option, you’re giving someone
else the right to buy the stock at a fixed price,
meaning the strike price. And that means
you’re obligated to sell the stock if the buyer
decides to exercise their right. So choose
your strike price carefully. In exchange for
this obligation, you’ll collect the premium
from the trade, less transaction costs, and
that reduces your breakeven point.;Let’s suppose you bought 100 shares of stock at $85,
and it promptly moved lower to $80.
The fix: Using the options prices from
Figure 1, you could, for example, sell the 85
strike call for $1.30. Subtracting $1.30 of premium from your stock purchase price of $85
leaves you with a breakeven price of $83.70.
And, once you’ve sold the call against your
long stock, you now hold a “covered call,”
which is a strategy some traders use from
the start as a means of generating income
when buying stock.
If the stock remains below $85 through
expiration, then your option will expire
worthless and you can go your merry way.
Or, you can choose to sell another call to
move your breakeven price even lower.
However, if the stock moves higher than
$85 prior to or at expiration, two things
could happen. One: nothing. Depending on
the days left until expiration, and how high
the stock goes, you might be able to buy back
the option to close it at a lower price than
where you sold it. That would be a win-win.
Or you might decide to ride the position out
until expiration and see where the chips fall.
Two: you might get “assigned”—
trad-er-speak that, in this case, means you
have to sell your stock. Don’t sweat it. You
simply sell the stock at $85, which is the
price you bought it for anyway. And you get
to keep the $1.35 premium you took in as
profit (minus commissions and fees). ;
The result: You don’t increase your risk
by selling the call option. You’re simply
lowering a break-even point and giving up
potential profit above your strike at the
same time. But you may find it worthwhile
to buy the call to close it out if it’s in the
money prior to expiration and you don’t
want to lose your shares.
LONG CALL or LONG PUT
The situation: Long calls and long
puts can be successful when the underlying stock is moving in the right direction.
But what if the stock takes a break, or even
starts to move against you? Or what if these
or some other factors cause the option’s
implied volatility to drop?
The fix: One way to save this trade could
be selling another option that’s further
out of the money (OTM) than the option
you own, but in the same expiration. This
turns your long option into a long vertical spread. The premium from the sale
of the further OTM option lowers the
trade’s overall debit by the premium you
FIGURE 1: Selling a short call option. Source: thinkorswim® from TD Ameritrade. For illustrative purposes only.
LONG CALL VER TICAL
Long Call Vertical