Option trading offers several key advantages that are not available to traders who deal only in the underlying securities. Not only is there the ability to leverage a market opinion while potentially risking only a small dollar value, there is also the opportunity to adjust a current open trade into some other position with an eye toward locking profits, increasing profit potential and/or reducing risk.
This article will detail an example of one such exercise. Namely, we will take a long call option position and adjust it into a directional butterfly spread. The purpose will be to lock in a profit while giving ourselves more time for profits to accumulate via either a continued advance in price by the underlying stock and/or by virtue of putting time decay in our favor under certain circumstances.
Stage 1: Entering a Long Call
The first step is of course the most difficult. For before a trader can adjust a long-call position into a butterfly spread, he must enter into a long call position and have it achieve enough of an open profit to offer the opportunity to adjust it into another position. So in essence, the first step is "get a winning trade." This is easier said than done, obviously. Still the purpose of this article is to focus on the adjustment part of the equation. So for our purposes we will offer a trade example of a long call. However, no one should assume that the simple method used to find the trade will work in all, or even a majority of cases.
In Figure 1 you see a situation where three "bullish building blocks" come together:
- The stock is above the 250-day moving average
- The Elliott Wave count is suggested a Wave 4 buy
- A slightly longer-term MACD (18, 37, 9) has just flipped to the bullish side.
|Figure 1 – Wave 4 Buy, Close above 200-day moving average, MACD flips to bullish|
In this example, in late February we will buy four July 115 call options at a price of $12 per contract. Thus the total risk on this trade is $4,800 ($12 x 100 shares per contract multiplied by four contracts). This represents the maximum risk on the trade. The risk curves for this trade appear in Figure 2. The maximum risk would be experienced if the trade is held until expiration and the price of the underlying stock is below the strike price for the option ($115). (For more information on option transactions, see The Ins And Outs Of Selling Options.)
|Figure 2 – Risk Curves for 4 July 115 calls|
Step 2: When to Make an Adjustment
There is no definitive answer to the question, "when should I adjust my long call position." However, the generic answer would be, "as soon as it makes sense." In a nutshell, as soon as a profit of a meaningful amount accumulates, and/or when a particular timing signal that you may be following occurs, it makes sense to at least examine the potential for adjusting the long call trade.
In Figure 3, you can see that the stock ran up a bit and that the three-day RSI did not confirm the latest new high in price. Once again, this is not presented as a definitive rule, only as an illustration of one possibility.
|Figure 3 – 3-Day RSI registers a bearish divergence; time to adjust long call position|
Step 3: Adjusting the Trade
In this example, as of the last day in the chart that appears in Figure 3, the original long call trade has an open profit of roughly $3,800. This is a "reasonable" amount of profit and it represents a good time to consider making an adjustment. In this case we are going to attempt to adjust this trade into a directional butterfly spread. Our objectives – if it is possible to achieve them at this time - are as follows
- Reduce or eliminate the risk of loss
- Allow time decay to work in our favor if possible (Learn more about time decay in The Importance of Time Value in Options Trading.)
- Retain unlimited upside potential
|Figure 4 – Position is Adjusted|
These adjustmentsmerit a bit of explanation.
- In the fourth line of data in Figure 4, you can see that we sold two of the original four July 115 call options. In this hypothetical example, they were bought at $12 and we now have taken the opportunity to take a profit on half the position by selling two at $21.50.
- In the third line of data in Figure 4, you can see that we sold four of the July 145 strike price call. This is the middle leg of the butterfly spread. The stock at the time is trading at $131.82, so here we are able to sell four call options that are roughly 13 points out-of-the-money and take in $2,200 in premium ($5.50 per contract x 100 shares per contract x 4 contracts). This will also allow time decay to work in our favor if the stock moves higher towards the 145 level.
- In the second line of data in Figure 4, you can see that we purchased four far-out-of-the-money July 175 calls. Two of the contracts represent the other leg of the butterfly spread (i.e., long two July 115 calls, short four July 145 calls and long 4 July 175 calls). In this example, we purchased two more calls (at a cost of $158) to ensure that the trade retains unlimited upside potential.
|Figure 5 – Risk Curves for Adjusted Position|
As you can see from a perusal of the risk curves in Figure 5, our new position has several key characteristics:
- The trade now has a locked in minimum profit of $1,400, no matter how far the underlying stock might fall.
- Time decay works in our favor if the stock remains between roughly 120 and 160.
- We retain the potential for unlimited profit if the stock decides it wants to take off and run to the upside.
These characteristics illustrate the power of being able to adjust an option position.
Step 4: The Exit
There is any number of reasons that a trader may ultimately decide to exit our example trade, and different traders will apply different criteria. Still, for illustrative purposes, in Figure 6 you can see that roughly a month and a half after the adjustment, the MACD indicator has flipped to a bearish signal. For our purposes we will treat this as an exit signal.
|Figure 6 – MACD flips to bearish – time to take profits?|
Figure 7 displays the risk curves as of the last date shown in the bar chart displayed in Figure 6. Over the past month and a half the stock moved up roughly another $8 in price and the adjusted trade accumulated some additional profits. At this point the trade could be exited for a profit of roughly $4,100.
|Figure 7 – Risk curves at the time of exit|
Timing a long call (or long put) trade is a topic unto itself. And the fact is that a successful long or call put trade must first be achieved before the adjustment illustrated in this article will be of much use. Nevertheless, it is important for option traders to consider the possibilities available to them. Many call and put buyers focus their attention entirely on deciding when to take a profit or cut a loss on a given trade. But as the example in this article illustrates, there are many possible ways to adjust an existing position and turn it into something else, while affording oneself a variety of benefits.
For related articles, take a look at Setting Profit Traps With Butterfly Spreads and What To Do When Your Trade Goes Awry.