Considering Our Options – Flies Gone Wild

by CC September 4, 2014 12:44 pm • Commentary

COST officially broke out today but the signs were there for the past week and a half. This is a trade that we managed badly and I want to go over how we should have done things differently because it also applies to two of our other trades at the moment. To recap, on August 13th we initiated a short delta trade on COST in the form of a slightly in-the-money fly that was essentially a short biased trade with the structure protecting against any decay. Here was the trade:

Trade: COST ($118.37) Buy Sept 120/115/110 Put Fly for 1.45

-Bought 1 Sept 120 put for 2.80

-Sold 2 Sept 115 puts at .80 each or 1.50 total

-Bought 1 Sept 110 put for .25

At the time of entry this trade essentially drew a line in the sand at 118.55 or about 20 cents higher than where the stock was. As soon as the stock was above that 118.55 level the structure went from one that was net short premium to one that was long premium and would suffer from decay. When managing in-the-money flies this should be our first sign of trouble and one where we should start to keep the trade on a short leash. The next level of worry on a structure like this is when the stock meaningfully gets past the upper strike of the trade (in this case the 120 line). This level is one where you are essentially betting that the stock will find resistance and the chances for the trade becomes dependent on that resistance holding.

In the case of COST, once the stock got above 120 we should have closed it for a loss and moved on. Now that the stock is significantly higher than that 120 strike the likelihood of getting anything back in the trade becomes a lotto ticket.

The reason I wanted to highlight this losing trade is because we have two other similar positions that are right on the edge of having to make the same decision we failed to do in COST. Those trades are in IWM and UPS.

On the case of UPS we didn’t start the trade as in-the-money as we initiated the fly when the stock was just below the top strike. But almost immediately afterwards the stock sold off towards our sweet spot. Since then, the stock has come back while the market rallied to new highs and it is now at risk of becoming out of the money. With the stock at 99 today the structure is only intrinsically worth $1 and we paid 1.45. In other words we need the stock below 98.65 in order for this to once again be short premium. The structure is currently trading about 1.25 so basically we need to stop this trade out if it looks like the stock wants to break out above $100 (our top strike.)

In the case of IWM the index is right at our long strike and we’ll need to make a decision even faster if this recent market rally has more legs. We paid 1.85 in the trade and while it’s currently worth about 1.15 that could be a much bigger loser unless the stock heads back down below our breakeven level of 115.15.

So we’ll be keeping a tight leash on both the UPS and IWM flies as we don’t want to sit and watch those break out of range as COST just did.