Avoid Locking in Losses When Rolling Options

what's up everyone welcome back to the show thanks for tuning in my name is Mike this is my whiteboard and today we're going to be talking about something to consider when we're rolling a trade or when we're converting an options trade into a stock trade and then continuing to reduce our cost basis against that so one thing that we can get tripped up tripped up with is our break-even point and sometimes we can actually sell an option that's way below our breakeven and actually lock ourselves in to a loss so today we're gonna walk through how someone might come upon that situation and how to avoid it by just paying attention to one simple metric and that is your breakeven so let's go into the first side and we'll talk about a few things to keep in mind when we're thinking about cost basis reduction so really when we were looking at cost basis production what we're trying to do is reduce the cost of trade entry in other words if I'm gonna buy 100 shares of stock at a stock price of 50 it would cost me $5,000 but alternatively what I can do is take those shares and sell a call against it with no additional risk and let's say I can collect $1 for selling that call I can now get into that trade for $4,900 in terms of cost basis reduction instead of five thousand so it's costing me less to get into that same trade yes I'm capping my upside potential but one thing we need to focus on is something that we can control and cost basis is one of those things so if I'm bullish on an underlying maybe I'll get into a covered call or maybe I'll sell a naked put but when I'm looking at cost basis it's the one thing I can control I never know where the markets going to go I don't know where implied volatility is going to go which are all things that are going to affect the price of the option and the overall P&L of my trade so if I focus on something I can control like cost basis reduction I'm gonna put myself in a good position for that strategy and when we're looking to manage that strategy regardless of whether it's a covered call or short put or an iron Condor whatever it is what we need to focus on is to always roll or adjust the strategy for a credit if we're adjusting strategies or rolling strategies for a debit we're actually increasing our max loss on the trade we're not adding to our max profit if things go correct for us and we're ultimately entering into a lower probability trade with no benefit if we're rolling for a credit we're entering into that lower probability trade for a benefit we're reducing our cost basis and we're improving our max profitability if the trade actually goes our way so what we need to do to focus on avoiding locking in losses with these situations is to really just assess and focus on the break-even point so what we're gonna do today is walk through a strategy we're gonna talk about selling a naked put and we're gonna let the naked put go in the money and we're gonna get assigned on those shares and we're gonna continue to reduce our basis by selling a covered call against that or ultimately just selling and out of the money call since we would already own the shares we're gonna analyze a few different situations and we're gonna weigh the pros and cons of each so let's go on to the next side and we'll talk about the very first trade which is going to be our short put so let's say we are looking at selling and out of the money put which is just going to be a put that's below the stock price because it has no real worth at expiration which is why it's considered out of the money if it was in the money it would be above the stock price because at expiration it would have worth someone would be able to sell their shares to us at a higher price if the stock price was below the strike but since it's above the strike as we see here it is out of the money and all of that value is going to be time and volatility value which is great for reducing our cost basis so let's say I'm looking at a ninety five strike put and I'm able to sell that for two dollars so I'm five points out of the money or five points below the current stock price and I've got a date sell expiration of 45 days which is what we've shown to be optimal from a P&L per day perspective and essentially a theta perspective as well so let's say I deploy this trade and I go ahead and sell that out of the money put which is going to have a much higher probability of success regardless of when I compare it to buying those shares right so if I were to buy those shares outright of course I would have unlimited profitability to the upside but selling this 95-foot I can actually profit if the stock price goes down to 99 98 97 even down to 95 as long as that put expires out of the money and worthless at expiration I'm gonna be able to keep that $2 credit but let's say that doesn't happen and the trade goes against us so over the course of 25 days the stock price has dropped from 100 to let's say right around ninety three and a half so what I need to know is first of all I need to consider what I want to do so I can either consider closing the trade for a potential loss or I can consider rolling the trade out in time or if I'm comfortable with owning the shares here as opposed to buying it at 100 if I'm very comfortable with owning the shares at 95 and including my cost that I collected which is $2.00 a premium for opening the trade it's gonna bring my breakeven down pretty low so let's say that at expiration the stock continues to drop down to 90 we're at expiration day we have to make a decision and we decide to ultimately accept the assignment of the shares so let's say that I allowed this put to expire in the money which would ultimately turn into 100 long shares of stock at expiration if we remember our short put is just the giving someone else the right to sell their shares to us because a long put contract is the right to sell shares at a certain stock price so if I'm selling that option I'm selling the right to someone else to sell their shares to me so that's exactly what's gonna happen so that's why selling a put is a bullish strategy because ultimately it will result in long shares of stock at expiration so let's say we're letting me put go in the money and exercise through expiration so now I would be long 100 shares at the strike price of 95 but I did collect a $2.00 credit which is still going to be valid because when I sold it there was all extrinsic values so all of that value is going to dissipate from the option at expiration so my loss is actually only three hundred dollars at this point as opposed to buying the shares at 100 I actually am long the shares at ninety five and I collected two hundred extra dollars from the premium for that contract so my breakeven actually goes from 95 down to 93 so that's what I want you to focus on on the next slide when we talk about the options that we have so we're gonna have the orange bar here be our break-even point and really we need to analyze the loss so compare the loss of $300 because our breakevens at 93 to a loss of $1,000 which is exactly what would happen if I bought the shares outright at 100 here so as you can see it's a huge difference we've only got $300 of loss right here we only need the stock price to go up to 93 for us to break even whereas if we were to purchase the shares outright at 100 we would have had the had to have the stock go all the way back up to 100 just to break even so now that we are into the shares and we've got 100 long shares of stock we want to continue to reduce our cost basis and we want to make sure that we're not locking ourselves into a loss by placing our strike and an incorrect or on up to mole situation so let's go into the next slide and we'll talk about a few different scenarios that we can walk through so now we're along the shares at 95 but our breakeven is at 93 as we have signified by this orange line here so the stock price is still the same and what we're gonna do is walk through three different scenarios of selling an option selling a call against these shares which does not require any more risk because the brokerage knows that I'm long 100 shares of stock so I can sell a call which is going to ultimately result in the opposite of a short put so these this short call here is going to result in short 100 shares of stock which means that I don't need to put up any more capital or take on any more risk because I'm already long 100 shares of stock at 95 so if the stock price comes up above the short call my short 100 shares which I would be at at this point are going to completely offset my long 100 shares that I already own which is why it's considered a covered call this would be a naked call if I did not have the shares but since I own the shares at 95 its considered covered because I don't have take on any more additional risk here so let's say that I've got my shares at 95 and I'm looking at selling an option at a few of these strikes so let's analyze what would happen here if I were to sell this option at the 100 strike I'm giving myself a ton of room to the upside for potential bullish movement in the underlying but on the flip side I'm only collecting about 10 cents to do so so what would my potential profit be well first of all we'd have to consider what would happen to our breakeven our breakeven would move from 93 down to 90 to 90 so basically what would happen is if I'm collecting 10 cents I can ultimately apply that to my breakeven and move it down to the downside so my breakeven would move from 93 to 90 to 90 and all I need to do to calculate my max profit is take the difference between my breakeven of 90 to 90 and measure it against my strike here so if I subtract 90 to 90 from 100 I get 710 and that's really what my ultimately max profit would be if the stock price ended up coming back up above this short call of 100 so yes I do have the ability to make a nice profit on this trade but there is probably a low chance of this happening where the stock price comes all the way back up to 100 and at the same time I'm only collecting about 10 cents so if it does not happen where if the stock price stay is right around there or maybe goes up a little bit I'm only reducing my cost basis by 10 cents so we have to think of the trade-off that we have here we're either collecting a smaller amount of credit for more potential upside movement if the stock price does come up to these levels or we can look at something that might be a lot more feasible which is moving our strike a little bit further down collecting more and giving up some of that upside profitability for a better breakeven so let's see what would happen here so let's say instead of looking at the 100 I'm not looking at the 95 so at the 95 I can collect 50 cents so my breakeven would go from 93 down to 90 to 50 and then I can just subtract my strike from 90 to 50 so I've got my strike of 95 subtract 90 to 50 and I get two dollars and 50 cents which is my ultimate potential profit at that situation so here we're looking at a much higher probability scenario of maybe the stock price does come up around here I'm able to collect five times more credit than I would if I sold this 100 strike and I'm still able to collect a feasible profit or a nice profit if the stock price comes up around 95 because we have to remember that our breakeven would be at 90 to 50 anything above the 95 strike would ultimately be offset because the short call here is going to replicate short 100 shares of stock and I've already have long shares at the 95 strike so what would happen is anything above this stock price nothing would really happen the short call would see losses but my long shares would see equal gains and intrinsic value so basically we would put ourselves at a better position in terms of reducing our basis because of that extra credit collection and we're still going to be able to get a nice profit but now we need to think about maybe moving a little bit lower below our break-even point and this is where it can get a little tricky so some people might own the stock at 95 not realize that their breakeven is actually at 93 and they might sell a call that's really close to the stock price and this is where we can get into trouble because if I'm selling something that doesn't move my break even below the short call I'm going to be locking in a loss so let's talk about how that happens so instead of looking at the 95 here we're gonna be looking at selling a 91 strike call so if I'm able to collect $1.00 in credit which is obviously better than the $0.50 here it still does not put us in a profitable situation so what happens is we collect that $1 and we move our breakeven from 93 to 92 but my short strike is at 91 so as we saw from this example anything that happens above 90 one is going to be counterfeit by our long shares so what does that mean well we're basically washed out at 91 and my breakeven is only at 92 so what does that result in that would result in a locked-in $100 loss so it's really important to realize where our break even is when we're analyzing the reduction in cost basis from these sort of trades because if we go much further down from our breakeven and we don't collect enough to move our breakeven below our strike we're gonna put ourselves in a locked-in loss position if I were to be able to collect five dollars for this call my breakeven would move down drastically and I would be able to be profitable in this situation but if I'm not able to move that breakeven down that's where we can get into trouble so it's really important to keep an eye on the breakeven when we're creating these sort of strategies so let's wrap all this together with some takeaways for you the very first takeaway we've got is to be aware of that breakeven one we're selling strikes obviously the credit collection is going to move our breakeven so managing the the relationship between those two is going to be key and making sure that we don't lock in the loss so we can go below our stock ownership but we need to make sure that our credit moves our breakeven lower than the short strike we sell in this covered call example and of course locking in losses isn't the worst possible situation losing $100 is still better than losing $1000 but it's not the best either so we always want to make sure we're putting ourselves in these optimal situations so be sure to keep track of the break-even when selecting strikes with strategies such as this so thanks so much for tuning and hopefully you like this segment if you've got any questions or feedback shoot me an email here or you can follow me at Joe trader Mike stay tuned though we've got Jim Schultz coming up next hi everybody I hope you liked this video click below to watch more videos subscribe to our Channel and don't forget to watch us live at tastytrade.com

Channel: tastytrade

Views: 46,755

Rating: 4.8607764 out of 5

Keywords: avoid locking in losses, how to trade, investing, finance, rolling options, rolling options strategy, rolling options trades, options trading, rolling options example, rolling options forward, how to trade options, rolling options explained, tastytrade

Id: 2imkRnyEv-k

Length: 14min 58sec (898 seconds)

Published: Wed Aug 10 2016