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Do As I Say, Not As I Do!

Posted by Pete Stolcers on June 13, 2006

No sooner did I post an option trading blog on legging out of spreads and I violated my own rule base – not really. Carl is one of my subscribers and he caught me in the act today. Here’s one of my own trades gone bad and why the situation is different.

About 5 weeks ago we sold the Goldman Sachs (GS) June 140 – 135 put credit spread for $.90 credit. The stock moved around and almost stopped us out once, but it bounced and rallied. With less than a week to go until expiration and with the stock more than $5 out of the money, I felt fairly confident that the stock would close above $140. I knew that the earnings would be released and like most people, I expected a good number. I also felt that the market would react favorably. My suspicions were right initially, but I did not want to see the stock give up any of its ground on such a bullish report. Within the first 15 minutes I was starting to see signs of strain in both the stock and the market.

The market has been very weak and it gave up its early gains without a fight. As I watched GS, I could see the selling pressure building. The other brokerage stocks (BCS, LEH, MER) had already cracked. This sector has lead the market higher and the early indications were that the sellers were focused on this island of strength. Without hesitation I knew I wanted to take risk off of the table. I watched the June 140 puts go from a $.55 offer to $.70 very quickly. That’s when I decided to buy in the June $140 puts for a $1.00 maximum. I figured that it would take most subscribers time to place the order and I gave the options some room to move. They traded from $.80 – $1.00 until 9:30 am CDT and then the door was closed. The market and the stock were headed south.

I did not want to sell the 135 puts. They were $.15 bid and with the overall market weakness I felt like I had a lottery ticket. Originally we got a $.90 credit for the spread and on average that’s what we paid for the 140 puts. The 135’s were basically free. In this instance I did not dramatically change the risk profile of the trade. I had made an early determination that I was wrong and I bought in the position before it was in-the-money (ITM). I did feel that if the market’s pattern held true and we saw afternoon selling that this $140 stock might get pressured. If it did, the premiums would jump and we could actually get some money out of the $135’s.

These plans don’t always work out, but in this case we were able to get $.90 for the puts. We turned a potential losing trade into a $.90 profit. To illustrate how hard it was for this to happen, we bought the $140 options in when the stock was at $144 and we sold the $135 puts when the stock was at $139. The stock had to move $5 in one day for it to happen and we had to be dead on right. As I mentioned earlier, we had a free put so there was not much risk. I certainly was not “sweating it out”.

Imagine if the leg left us holding a $6.00 option that was moving in $.20 increments. When you spend months trying to grind out $.80 credits here and $1.00 credits there, a leg of this nature can destroy a year’s work in a matter of minutes.

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