How to Recover When Your Option Trades Turn Against You
by Karim Rahemtulla, Investment U’s Options Expert
Tuesday, December 7, 2010: Issue #1402
“Your articles are wonderful to read. So clear. I do dabble in naked puts, but have not yet learned how to recover when things turn against me. Will be looking forward to your next promised article.”
So said one Investment U reader in response to my article last week on how to sell put options.
First of all… thanks for the positive feedback. Glad we’re educating you well. But the reader brings up an interesting point that I want to address today…
It’s all well and good when you’re making money in the options market and the strategies you’re using are working perfectly. But what happens when a position turns against you and you have to bail out to mitigate your losses?
I’m going to show you how to do that, focusing on two strategies here – put-selling and covered calls. I’ve used both with great success over the years, but there have been some negative trades along the way, too. So here’s how to get yourself out of an options jam…
A Covered Call Bailout Strategy
First, let’s focus on the covered call trade.
To remind you, this trade involves holding at least 100 shares of a company’s stock, then selling call options against them (one options contract for every 100 shares you own).
If the underlying stock declines, you’ll begin to see the option’s premium erode, too. But depending on the timeframe of the trade, you may see a greater loss in your stock position in real dollar terms than you will in your option position.
To calculate your exact current position in the trade versus when you placed it, you must:
- Get the quote for the stock.
- Get the quote for the option.
- Subtract the current option price from the current stock price.
- Compare that number to your net cost of the trade when you executed it.
If the new net number is below your stop-loss threshold – let’s say 20% – then you have the following options:
- Either: Stick with the position and hope that the share price recovers, so you can sell another option at expiration.
- Or: Reverse the trade by buying back the current option and selling the stock. You can also buy back the option and sell another one at a lower strike price to mitigate some of the loss. However, if the new strike price you choose is below your cost, then you’re going to take a loss there, too.
But there’s one way to pretty much avoid this situation entirely…
Sell deep-in-the-money calls against your position.
While this does reduce the overall return available, the upside is that it also reduces your net cost significantly and thus provides a nice cushion against risk.
On to the second way you can “get out of jail” when an options trade goes against you – this time with put-selling…
A Put-Selling Protection Plan
As I’ve explained in recent columns, when you sell a put option on a stock, you’re receiving money (a premium) for the obligation to buy the corresponding number of shares at the strike price you select.
For example, if you sell one January 2011 $30 put option contract on Starbucks (Nasdaq: SBUX), you’re obligated to buy 100 shares for $30 per share if the price falls below that level by options expiration.
In theory, though, your hope is that Starbucks shares are trading above the strike price at expiration, so you get to keep the money you received with no obligation. (Unless you really don’t mind owning the stock and are okay with the purchase price.)
However, it doesn’t always work that way.
If Starbucks shares fall below the $30 strike price prior to expiration, you’ll see the value of that put increase – which you don’t want, as it means you’re now sitting on an unrealized loss. Your choices here?
- Either: Buy back your put and realize the loss.
- Or: Wait until expiration and hope that the shares recover and finish above the $30 strike price. The risk here, though, is that if they continue to fall, your loss will be greater.
In order to minimize your loss, you can sell puts that are deeper in-the-money (i.e. lower than the current share price), so the stock has to fall further before you’re “put.”
Alternatively, you can buy a put option at a lower strike price, which would mitigate your loss beyond a certain level if the shares are freefalling. Keep in mind, though, that the extra money you spend on buying a put option will reduce your profit or increase your loss on the trade, depending on where the shares ultimately close.
The solution here is simple: Only sell puts on stocks that you want to own. That way, you erase the worry if the stock falls – and are, in fact, happy about it because you’ll get to buy the stock at the price you want.
About Karim Rahemtulla
With more than 20 years of experience, Karim has mastered the subtle art of options trading. What we admire about him is his ability to score huge gains while minimizing the massive amount of risk that often comes with options. Beyond his expertise in options trading, he is also the author of the best-selling book Where in the World Should I Invest? He publishes weekly about smart speculation in his latest free e-letter, Trade of the Day.