In our latest series of articles we have discussed a bull put credit spread options play for Priceline (NASDAQ:PCLN). When entering any investment strategy, even just a long stock position, you must have your exit strategies and potential management techniques planned out for the various outcomes. In options trading this is even more essential as numerous possibilities for management exist - some that may reduce the initial risk and others that may increase the potential for loss on the position. An investor needs to plan ahead of time for potential adjustments before placing such a spread trade.
Here are the specifics for the PCLN bull put credit spread discussed on November 14th, 2012:
Bull put credit spread for Priceline :
Sell 1 DEC 600 strike put @-$11.10 (-$1,100.00 per 1 contract)
Buy 1 DEC 595 strike put @ $10.20 ( $1,020.00 per 1 contract)
Initial net credit = -$ 0.90 ( $ 90.00 for 1 contract spread)
Maximum risk / margin requirement = $ 4.10 ( $410.00 for 1 contract)
Percent maximum return = 22% ($0.90 max. gain / $4.10 requirement)
This is a bullish position where the maximum profit is realized if the stock is trading above the sold 600 strike put at December expiration. A loss occurs if the stock falls below the break-even point at expiration, with the maximum loss realized if the stock is trading below the purchased 595 strike put at expiration. The curved red line shows us that we may experience an unrealized loss on the position if the stock falls in price at the half-way point or other times prior to expiration.
Lower Stock Price Limits:
Since this is a bullish strategy we want to plan ahead to make adjustments if the stock goes against us. Even though we have entered an options spread, we first want to establish a lower stock limit as a trigger point to plan for adjustments. A common approach by stock investors is to use a stop loss of -8% or -10%, meaning that if the stock drops 8% or 10% from their purchase price they will look to close the position to limit further losses. In a spread position we do not own the stock, but we could use a percentage decline on the stock price at the time the trade was entered.
The standard approach for using a lower stock limit poses a problem when using a spread position. To obtain the net credit and desired return, the short put in this bull put spread was only about 6% out-of-the-money. If we set a lower stock limit of -10% (which would be a loss of -$63.80 from the stock price when the spread was entered) PCLN would have already breached our short put strike price potentially resulting in significant, unrealized losses.
Rather than use a percentage decline for the underlying security as a lower target, we prefer to use a percentage of the sold option as a target price where we might consider adjusting the spread to limit further losses. A good rule of thumb for spread investors is to use a target price of 1% to 1.5% of the sold option strike price.
In the case of the PCLN bull-put credit spread, we would set a lower target limit of $606.00.
Sold put strike price = $600.00
1% of sold put strike = $ 6.00
Target price to adjust spread $606.00
This would not be a stop-order or contingent order that we would place with our broker to simply liquidate the position if PCLN dropped to $606.00. This would be more of a mental stop-order that we would use as a target to consider adjusting the position. Before we discuss some of the basic adjustments that might be used to manage a bull put credit spread, we first have to discuss the lower stop limit in relation to time. When we first analyzed this position December expiration was 38 days away. In a volatile stock market we have to be aware of what our position would look like if PCLN dropped to $606.00 in 1 week, half-way between now and expiration or a few days before expiration.
Using the calculate expected profit and loss feature on the PowerOptions Profit / Loss chart we can view the potential loss on our spread if PCLN dropped to $606.00 on November 21st, one week after the spread was entered:
This view shows us the potential monetary values of our options, based on the Black-Scholes pricing model, if PCLN dropped to $606.00 per share on November 21st. In this scenario we would still have 31 days to expiration. Based on the theoretical pricing models we see that our sold DEC 600 put would have a potential value of $16.04 (we would have to pay $1,604.00 to buy to close our short put and cancel the obligation). Our long put would also increase in value to $13.83 per contract or a gain of $363.00 per 1 contract, but this would not counter the loss we would take on the short DEC 600 put. This shows us that we would have a theoretical loss of $131.00, or $1.31 per contract if PCLN did fall to our lower target within the first 7 days of the trade. This is only 46.5% of the maximum potential loss of $4.10 per contract but would still be a significant set back to our trading plan.
As we get closer to expiration the time value will decay on both options which works to our advantage. Here is how the position would theoretically look if PCL dropped to $606.00 on December 4th, the half-way between the open date and expiration:
Unfortunately we do not see much difference in the expected, theoretical loss even though more time has passed and we are closer to December expiration. Both options have a theoretical value of $500.00 less than the first scenario, but we still see a fairly large theoretical loss on the spread.
As we enter the last week of expiration we can expect more of a favorable decline in our spread position:
In this scenario we see that theoretically both options would decay significantly and a small profit could potentially be realized for closing the position. However, if the stock was still trading above our short put strike price with only a day or two remaining in the trade, we may consider leaving the position open hoping that both options would expire worthless and we would realize the full net credit.
Why is it important to analyze the potential gains or losses for different time frames on a spread, or any, position? It is important to know the theoretical losses if the stock hit our mental stop at these time frames because different adjustments may work better if the underlying hit our adjustment target price in one week, half-way to expiration or just before expiration.
What adjustments might we use?
There are basic adjustments that spread investors use to reposition their trade or attempt to lower their losses. The first is fairly obvious but not really an attractive scenario.
Adjustment 1: Liquidate the Spread
If PCLN drops to our mental stop point at any time we can simply chose to liquidate the spread and take a loss on the position. This adjustment is not desirable as a loss will be realized, but it is a defensive move to prevent larger losses if the stock continued to move against us. The action, or order, we would use to liquidate the spread would be: Buy to close DEC 600 put, sell to close DEC 595 put. If this happens shortly after the spread is open we will realize a larger loss compared to liquidating the position if our lower target is hit closer to expiration. In either case, it still prevents us from realizing the maximum loss on the spread if the underlying security continues to move down in price.
Adjustment 2: Buy to close the short leg, leave the long put open
In this adjustment we might realize a larger loss upfront as the cost to close the short put is not countered by selling to close the long put option. This adjustment is best used if the stock hits the mental stop in the first week or around the half-way point of the trade. By leaving the long put open we may see an increase in the put price if the stock continues to move against us. If PCLN declined below $595.00 by December expiration we would be able to close the long DEC 595 put for its intrinsic value, hopefully countering the initial loss taken for closing the short leg. This adjustment is not advisable if the stock hits the lower target in the last week of expiration as it is less likely to see the decline needed in the underlying stock to see increased value in the lower strike put.
What happens if the lower target is reached, we close the short leg and the stock recovers? This would present an opportunity to re-sell the short put if we still had time remaining to expiration. We may not be able to take the same or higher premium if we re-sell the DEC 600 put at a later date, but we still may be able to realize a positive credit on the position.
Adjustment 3: Roll down the spread
If our lower target is reached at any point we may attempt to roll both legs of the spread to a lower strike prices, either in the same expiration cycle or further out in time. To roll the spread we would close both legs as described in Adjustment 1, then we would look to open a new position such as:
Sell to Open DEC 590 put
Buy to Open DEC 585 put
If our lower target is hit in the first week or at the half-way point we may be able to keep the same expiration cycle and still achieve a credit. Using the theoretical losses discussed earlier we may have a loss of -$1.31 per contract if the initial spread was closed in the first 7 days and a loss of -$1.19 per contract at the half-way point. In order to remain profitable the new spread that we would open would have to have a net credit greater than $1.31 or $1.19, respectively. If we could not achieve a new net credit that is greater than our initial loss in the same expiration cycle we might consider opening a spread farther out in time, such as January 2013 or February 2013.
Rolling down the spread to lower strike prices may seem attractive but one must carefully evaluate the underlying security and current market conditions before simply rolling the spread. If the stock continues to decline in price you may have to roll the position again, and again, and again. Continually rolling down the spread can result in much larger losses than you initially anticipated if the security continues to move against your market sentiment. One could view this as the old cliché, 'trying to catch a falling knife'. In some cases it may be best just to liquidate the spread and take the loss if your sentiment on the stock has changed.
These are just a few basic ideas on how to manage a vertical spread if the underlying security moves against your market sentiment. If the stock stagnates or stays within a tight range after the bull put spread has been placed, one might consider selling an out-of-the-money bear call credit spread to create an iron condor. If the stock moves up quickly after the initial bull put credit spread was placed, we may consider closing the position early for a profit. A good rule of thumb here is the 80/20 rule - if we can close the spread early and realize 80% of our potential maximum profit, it may be a good idea to take the money off the table now rather than risk a pull back in the stock.
What management techniques have you used to manage a spread that has gone against you?
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.