An actual trade example

We generally publish information on actual trades in client accounts for only clients to view.  In this way, we keep the details of our actual trading strategy somewhat obscured to the general public without leaving clients in the dark.

Given some of the volatile activity we have seen in the stock market over the course of the last week, it makes sense to us to publish the specifics of a live trade we took in most of our clients’ accounts last week, and to allow all registered members of the site to view our commentary.

As the market began to drop on Tuesday, we jumped at what we thought was the opportunity we had been waiting for.  One type of position we use in building our clients’ portfolios month to month is the short vertical spread.  A vertical spread is made up of one short option contract and one long option contract on the same underlying for the same expiry month with a different strike price.  When we sell a vertical spread to open a position, we create risk in the amount of the difference between our long and short strikes.  The option we have sold is worth more than the option we have bought, thus creating a credit in the account, which we hope to keep most, if not all, of.

Specifically, as the market dropped on Feb. 27, we sold a March put vertical in the SPX at 1385/1375, with the SPX at about 1431.  This position consisted of a short March 1385 put and a long March 1375 put, both in the SPX.  This makes our risk equal to the distance between 1385 and 1375, or $1,000 per spread in this case.  However, we also collected a premium, since we sold a more expensive put than we bought.  The premium was $0.75, meaning each account was credited with $75 per spread, making our actual risk $925 per spread.  The objective of this trade was to see the SPX remain and expire well above 1385 on and before March 16, 2007.

Given the unfavorable risk/reward conditions which exist in a position like this, i.e. a high probability of a small gain and a small probability of a large loss, risk management is key.  See the P/L diagram below.

Fast forward to the last hour of trading in Feb. 27…

The market has completely melted down since we entered this position, moving closer to our short strike at 1385, thus creating paper losses in our clients’ accounts.  The market closes at around 1399, still at a relatively safe distance from our short strike, but we sense that this move has not entirely run its course. 

On Wednesday, Feb. 28, we get a bounce in the SPX, albeit a small one as compared with the huge downdraft from the 27th.  As we closely monitored the market internals, it became increasingly clear to us that the bounce had most likely run its course for Wednesday, and it would be wise to cut the losses on our short put vertical.  Our broker gave us a quote of $2.20 to cover the short vertical spreads, and we received a better fill of $2.00, leaving us with a loss on the position of $1.25, or $125 per spread.

On Thursday morning, the SPX spiked down through our short strike to almost 1380 before it managed a bounce which did not last.  As I write, the SPX is trading at 1381 again, and it has been as low as 1376.84.  Not only that, but VIX is higher now than it was when we covered the short spread position, meaning we would be buying back more volatility now than we needed to in order to cover.  Bottom line, if we were to attempt to cover the spread right now it would cost us nearly $5.00.

We post this to demonstrate a couple of things: 1) Yes, we do make mistakes every now and then (note the tongue in the cheek), and 2) we try to stay away from the “hang on and hope” approach to position management.  Had we stuck to our guns with this trade, at this point all we would be left with is hope that the market would come back up at least a little to mitigate our losses.  Could it do that?  Of course.  The SPX would only need to settle 5 points higher on expiration day in order to leave this position on the max profit area of the diagram shown above.  Are we willing to gamble that it will?  No way, not at this point for the little bit of premium we collected to offset whatever losses we might encounter.  Besides which, other positions in our clients’ accounts have been primarily short call verticals, meaning this pullback is just what the doctor ordered, leaving most clients net positive for the month of February despite the late month pullback.