Earlier I answered a a question over email from a subscriber who found himself in a bit of a pickle on a trade and wanted our thoughts. I want to share the situation because it’s not at all uncommon and not the worst thing in the world. Also, because of what just happened in the market the first few months of the year, it could be fairly prevalent out there right now.
Here’s the situation:
In late January 2016 I guessed wrong and bought Under Armour (UA) at about $84 a share. When the stock collapsed I sold the Jan 2017 85 calls for $5.50 to reduce my loss. The stock as you know has rebounded and today trades more the $85/share. The calls I sold at $5.50 now trade at about $10.50. Should I wait until the calls do not have time value, sell the shares and buy Jan 2017 calls to match my liability or what do you suggest?
When a stock starts to drop right after you buy it you’ll often hear people (or in my case, people in my head) say “Do something!”. One of the things people do is to sell an upside call. The problem though, is if the drop is sharp enough the only calls worth selling on the upside aren’t really that “upside” from where you bought the stock. In this case the only call the questioner could find with any meat were the Jan 85’s, at $5.50. The problem with that strike is it’s just $1 higher than where he bought the stock. So when you do get that reversal quickly you can be trapped. But let’s look at just how trapped he is. I would argue it’s not that bad. But the error can be compounded!
Let’s look at the current position. Right now he is synthetically short the Jan 2017 85 puts at 6.50.
Here’s how you calculate that:
- Bought stock at $84 ($1 below the 85 strike)
- Sold an 85 call at 5.50
- 5.50+1 = 6.50
So the most he can make is $6.50. And his risk below his breakeven of $78.50 ($85-$6.50) is unlimited like stock. So how does he wiggle out of it? There’s no perfect answer… but the key thing to remember is the position is still bullish (it is long about 45 deltas).
If UA were to go up from here, he would make money (or lessen losses) and if it goes lower he would lose money (increase losses). So the worst thing one can do in this situation is to close the calls. Because you’re adding deltas up here after selling some lower.
Assuming his intention is to stay long UA for some time his best bet is to be patient. He asks whether he should maybe sell the stock and buy a call, but there’s really nothing you’d want to own that’s not just like stock anyway (100 delta in the money options in Jan) If he is patient he can sort of root for the stock to go both ways. If the stock pulls back a little he has less of a loss in the short calls, and the opportunity to either cover those short calls and just be long the stock once more, or even better turn that short call into a 1×2 by selling another and BUYING a lower strike Jan call to add leverage to his long. In that situation, the next time the stock comes back to strike, he’d actually be up money and have a breakeven higher where he’d be willing to be called away.
The key thing on this trade an any management from here is that it is still bullish even though it doesn’t feel like it with the stock already above strike. The worst thing to compound the error of selling deltas lower is to add deltas here. The second way to mess things up is to sell deltas here as it’s sort of taking away the most realistic way you can turn this trade profitable again (which is being patient and letting the stock either go sideways (and collecting decay) or letting it go higher and making the difference between the stock and the premium sold (6.50). And there are opportunities to wiggle out of it with the stock lower, as I mentioned, by closing the short calls, or turning it into a 1×2 or a call tree.