With U.S. equities up a fast 4.2% since last Tuesday’s low, the bulls have experienced quite the reversal of fortune after the prior week’s market swoon. Those clairvoyant enough to buy the blood during that week have been rewarded with significant profits in some instances.
For the lion’s share of traders, these gains often invite greed onto the playground — where it threatens to thwart their objectivity.
Becoming too optimistic after large market runs can lead to a whole host of errors that rob traders of hard-fought gains. While fully banishing greed from your trading may lie outside the realm of possibility, containing its influence is achievable. Consider the following three techniques you can use for a profitable call option trade.
Click to EnlargeLet’s assume a trader purchased 10 contracts of the Wal-Mart (NYSE:WMT) Aug 67.50 call options at $4. Given the recent rise in the retailer, the calls have climbed to $7, leaving you with a $3, or 75%, gain.
Rather than waffling between staying all-in or getting all-out, traders could consider closing half of their position. Consider this a psychologically easier compromise that captures some gains while leaving you open to additional profits. It creates a win-win scenario regardless of which path the stock travels after you exit half.
Call Roll Up
The call roll up consists of selling your call options and buying calls with a higher strike price in the same month. Because of the rapid rise in WMT’s stock price, the AUG 67.50 calls have moved deep in-the-money, causing a substantial rise in value. This increases the amount of money in the position and thus your downside risk. At trade inception, your 10 WMT Aug 67.50 calls were worth a total of $4,000. Now, they’re worth $7,000.
Traders could sell the 10 Aug 67.50 calls at $7 while buying 10 Aug 72.50 calls for $2.50. This effectively reduces your position from $7,000 to $2,500. In the event WMT continues to rise, you’ll continue to rack-up additional gains. If it drops, you have much less money at risk.
Roll to Call Spread
Yet a third option to consider is rolling to a vertical call spread by selling a higher-strike Aug call against the long Aug 67.50 calls. For example, traders could sell the Aug 72.50 calls for $2.50 to enter a $5-wide $67.50-$72.50 spread for $1.50 debit ($4-$2.50). The extra $2.50 brought in from selling the higher strike call reduces the overall cost, and therefore risk, of the position from $4 to $1.50. On 10 contracts, that drops the net debit from $4,000 to $1,500.
On the upside, it also allows the additional accumulation of $500 of profits on the 10 spreads.
As you can see, traders have a variety of adjustments at their disposal for curbing their inner pig. In the end, the desired modification depends on risk tolerance, personal preference and the trader’s outlook moving forward.
At the time of this writing Tyler Craig had no positions on WMT.