Options Questions Answered

This week, as I occasionally do, I’ll answer a couple of questions that readers have sent in regarding options.

The first has to do with setting stops on short put trades. Selling puts short is a strategy that takes advantage of time decay in cases where we are neutral to somewhat bullish on a stock. We select a demand zone (support area) that we believe the stock will remain above until a nearby option expiration, and sell puts with a strike price below that level. As long as the stock remains above it, we keep the money received for selling the puts, which expire worthless. Here is the question:

… there is the question of exactly where to set the stop… After determining the demand zone and selling the put, if the underlying drops in value, the quote on the puts will go up (other things being equal). Thus the open profit in the put trade will go down, as the cost to buy to close goes up, I believe.

Correct.

It would seem that I should place a fairly tight stop to avoid losses. It is my conclusion that the principle is to properly select the Demand Zone and place the stop very close to the lower limit of the DZ

Yes

or, if the underlying is out of the DZ, just below the price of the underlying, to minimize losses.

No! Whether the underlying is above the demand zone or in it, the stop still needs to be below the zone. This zone is by definition the barrier that we expect the stock to respect. We should not place the stop above this barrier if the stock is above the zone; and we would not take the trade at all if the stock was already below the zone, of course. If this stop is too far away from the current price to yield a good reward/risk ratio, then we need to look elsewhere.

Placing a firm stop would also have the advantage of setting the trade and leaving it to minimize future “emotional response.” Is this correct?

Absolutely. In options especially, it is vital to “plan the trade and trade the plan.”

Next, I had an interesting trade submitted for comments. Here it is:

My latest income strategy has 16 contracts on TSLA 2/21 chosen for volatility yet attempting risk management. I placed the trade at different intervals:

Sold 4 215 calls at $2.37

Bought 4 225 calls at $1.48 When market kept closing up

Sold 4 155 puts at $ 3.78 when trading above $200 last week

Sold 4 230 calls at $2.48 this along with the puts to hedge the 215 call risk

I would love your critique.

Let’s look at a chart of this stock as of the date of this message, February 18:

Now let’s unpack this trade. This is the first leg:

Sold 4 215 calls at $2.37

This was a bearish trade, a speculation that TSLA would remain below 215 until the Feb 21 option expiration. This trade was made late in January. At that time TSLA was making a run at its previous high around $195, but had not yet broken it. The $215 strike was more than 10% above the old high, and its upward momentum seemed to be flagging.

But there was one big issue with this trade: Tesla was scheduled to report earnings on February 19, two days before expiration. This alone made this an extraordinarily risky trade. If TSLA moved above $215, the potential losses on the short calls were unlimited. Realizing this, the trader added some additional elements. Let’s check them out.

Next leg:

Bought 4 225 calls at $1.48 When market kept closing up

Adding these long calls at a higher strike converted this trade from naked short calls (unlimited risk) into a bear call spread (limited risk.) At this point the net credit taken in was the original $2.37 less the $1.48 cost of the 225 calls, or $.89. That was the maximum profit, which would be made if TSLA stayed below $215. Maximum loss would occur with TSLA anywhere above $225 at expiration. In that case it would cost $225 – 215 = $10 per share to buy our way out of the spread. Subtracting our $.89 credit, that would mean a maximum loss of $9.11 per share. Our upside break-even price was now the short call strike, $215, plus the $.89 net credit, or $215.89. Adding the long calls had reduced the risk, but it was still quite high compared to the maximum payoff.

Then the following were added:

Sold 4 155 puts at $3.78 when trading above $200 last week

Sold 4 230 calls at $2.48 this along with the puts to hedge the 215 call risk

These additions hedged the risk in one sense – their added cash flow improved the maximum profit, and with it the upside break-even price. Having taken in another $6.26 per share, our total net credit was now $6.26 + $.89, or $7.15. Since our position would still begin losing to the upside as soon as the $215 lower short call strike was reached, our upside breakeven was increased by the additional $6.26 in credit received, from $215.89 to $222.15.

However, having sold puts, we now had a downside breakeven price as well. In the unlikely event that TSLA dived below the $155 put strike, all the calls would be worthless, but our short puts would begin to cost us money. We would lose our $7.15 credit at $155 – $7.15, or $147.85. Below that our losses would be unlimited (or close enough – IF TSLA went to zero, we’d have to pay $155 per share to buy the puts back).

Meanwhile, adding the short 230 calls had turned the trade back into one with unlimited risk to the upside. If TSLA went above the 230 strike, then we would have two short calls losing money (the 215s and the 230s), and only one making money (the 225s). The net result was unlimited upside losses above $230.

When all was said and done, the P/L picture for different prices at expiration looked like the diagram below. It resembled a sort of modified short strangle. Its main features were (all numbers are per share):

Maximum profit $ 7.15, at any price between $155 and $215

Maximum loss unlimited in both directions.

Upside breakeven $222.15

Downside breakeven $147.85

Was this a good trade?

First, the trader showed great ingenuity in adapting the trade to evolving conditions. Maintaining and evolving a position into one that will be profitable in case of what is considered the most likely price movement, is the mark of an experienced and resourceful trader.

BUT – the main criticism I have is the one I mentioned above. This stock was not likely to sit quietly until expiration, since it was going to report earnings just before then. For the same reason, implied volatility was almost certain to continue increasing right into the earnings date. Since the position was short a great deal of time value, this would hurt if it had to be closed out. Finally, betting against a company like Tesla which has been on a tear, was a very, uh, aggressive move.

All in all, not a trade I would have been comfortable taking.

So how did it work out?

At expiration on February 21, TSLA closed at $209.60, after topping out just a hair above $215. The trade made its maximum profit of $7.15. Which indicates that this trader is a genius at predicting price, and/or extremely lucky. I congratulate him on the win, though it’s not a trade for the faint of heart or wallet, and not one that I would have taken.

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