Locking In An Options Profit

The first post in this series “Follow Up Options Tactics” is here. This is the follow up example from Options as a Strategic Investment.

A call buyer bought an XYZ October 50 call for 3 points when the stock was at 48. The stock has since risen to 58 and the October 50 is now worth 9 points with plenty of time remaining to expiration.

We presented four tactical choices for the call buyer:

1. Liquidate - take the $600 in profits and close out this trade.
2. Roll-Up - Sell the October 50. Pocket the $300 initial investment and use the $600 to buy out of the money XYZ calls that have a reasonable chance, according to the volatility, to be in the money at expiration.
3. Spread - Create a bull spread by selling a same expiration out of the money call against the profitable October 50 long call, preferably getting at least as much as the $300 cost of the October 50 and going into a zero risk situation.
4. Do Nothing - Hold the October 50 until sale or expiration. This is the only tactic that can result in total loss of the initial investment.

What are the alternatives to Tactic 1 - liquidating and pocketing the 6 points, and Tactic 4 - doing nothing, that would allow the call buyer to reduce some of the risk of staying in the position without giving up on the possibility of greater profits?

The XYZ October 60 call is selling at 3 points. The call buyer could liquidate his October 50 call for 9, buy two October 60 calls, and put $300 in his pocket. One of the attractions of this roll-up tactic is that the vanilla options trader is now playing with house money. He owns two calls for free, doubling his position, and every penny of appreciation in the October 60 call is pure profit.

If XYZ stock continued to rise substantially above the 60 strike price then Tactic 2, the roll-up, would provide the greatest reward. If ZYX stayed the same or fell backwards before expiration, however, the roll-up becomes one of the worst choices.

The final alternative, Tactic 3, has the distinct advantage of never being the worst choice.

The call buyer initiates this tactic by holding onto his October 50 call, for which he paid 3 points, and selling the October 60 call for 3 points. Because the sale of the October 60 call (the short side of the spread) matched the cost of his October 50 call (the long side of the spread), the call buyer is in the position for zero risk no matter what XYZ stock does between now and expiration.

Tactic 3 is called a bull spread.

(ed. You need a margin account and must meet minimum equity requirements to create option spreads.)

The maximum potential profit in the bull spread is 10 points, the difference between the higher short strike and lower long strike. The maximum profit can be realized only if XYZ is at or higher than 60 at expiration because the October 50 call would always be worth exactly 10 points more than the October 60 call no matter how much above 60 XYZ stock ended up.

Tactic 3 is the best choice if XYZ remains above the lower strike price but relatively unchanged at expiration. If XYZ drops below 50 then it is a better choice than doing nothing because the call buyer does not experience a loss. If XYZ rises above 60 then the 10 points profit from Tactic 3 is a better outcome than the 6 points the call buyer would have received from liquidating. And again, Tactic 3 is never the worst performer of the four choices.

You can quickly set up a matrix with real numbers to get a handle on the possible outcomes for each of the four choices.

The best or “right” choice at any given time is not going to jump out and bite you. Successful options trading is about cooly managing the probabilities. Part of that is setting a range of realistic outcomes for the future price of the underlying stock. Implied Volatility is the tool of the options professionals. You can see our Vanilla Options Toolbox video here. It’s a freebie with any of our ebooks.

In the next post in the series we will cover some defensive options strategies you can use to salvage a position when the stock moves against you.