I don’t usually make new Year’s resolutions because I rarely keep them. But in my world, there are times when you need to reassess how best to deal with the operational aspects of trading options. Unfortunately, these reassessments usually are the result of costly mistakes.
Resolution 1: Avoid expiration nightmares.
Always remember that options do not expire on the final day of trading. They exist as a contract until the Saturday following the final day of trading. Take as an example the December 2015 expiration of options on Canadian National Railway Co. (CNR). On behalf of clients, I had sold more than 60 CNR December 78 calls, which were covered by the underlying shares.
On Friday, Dec. 18, the final day of trading for the CNR December options, the stock closed at $77.85 a share – an ideal situation. The shares closed just below the strike price; the options expire worthless; clients keep the stock and, for good measure, Dec. 18 is my birthday. The world seemed … right!
I got another present on Monday morning: CNR shares rallied at the open and remained well above $78 a share throughout the day. I decided to sell the 6,000 shares (the shares covering the now expired short option position) during the day and open a new covered-call position with a different underlying stock.
On Tuesday morning, my in-box had a notice from our custodian that we were short 2,000 shares of CNR. Apparently, there was a forced exercise of 20 CNR December 78 calls on Saturday, Dec. 19. So, the Monday sale of CNR shares occurred in accounts that no longer held the shares.
I had to enter a “buy” order for the shorted 2,000 CNR shares on Tuesday morning (positioned through our error account to ensure that no client was harmed).
Two lessons from this scenario:
1. Just because the underlying stock closes out of the money does not ensure that short options will not be assigned. The holder of the options can force an assignment no matter what the price for the underlying shares at the market close on Friday.
2. Ensure that you review all option assignments on the Monday morning following expiration – before making any changes to a portfolio.
Resolution 2: Don’t “leg into” spreads
Spreads are a common option strategy. They help reduce risk, provide excellent risk/reward characteristics and can be used to fine-tune your outlook for the underlying shares.
The spread strategy is straightforward: you buy a call or put, then sell another call or put with a different strike price and/or expiration date on the same underlying stock.
For example, XYZ is trading at $55 a share. A client who is bullish may buy an XYZ July 55 call at, say, $3 and sell an XYZ July 60 call at, say, $1 – for a net debit of $2 a share. The problem is not the strategy; rather, in how the strategy is executed.
Many investors attempt to “leg into” the spread by taking on one side of the spread transaction, either by buying the 55 calls or selling the 60 calls, then “legging” into the other side once the first trade has been executed. The challenge is that the underlying shares can move dramatically when trying to time the remaining side of the trade.
The resolution is simple: never leg into spreads. Always enter a spread as a net debit or net credit position. With the XYZ example, the options order would be entered as a spread with a $2-a-share net debit. Under this scenario, your client is indifferent about the price paid or received for the position; the concern is only that the cost is no greater than the net debit stipulated in the order.
Resolution 3: Know the personality of your client
Clients deal differently with the stresses associated with investing – so much so that one of the fastest-growing topics in investment literature is behavioural finance, which examines how investors react emotionally to specific stresses.
One of the more prominent concepts is Prospect Theory, which looks at how clients deal with risk. Studies show that clients will react more intensely to a loss than they will to upside underperformance – by a factor of two to one, if you believe the surveys.
The effect is that you are twice as likely to lose a client if their portfolio declines vs rising, even though that portfolio underperforms a benchmark.
Now, let’s apply that theory to options: how clients deal emotionally with the execution of specific strategies.
For example, using the XYZ spread example, there are two ways to take a bullish position on the underlying shares. The example cited was a bull call spread in which your client risks a $2 net debit for the potential of earning $5 should the stock rally above $60 a share.
However, you also can execute a bull spread using put options. In such a case, your client might sell the XYZ July 60 put at, say, $6 and buy the XYZ July 55 put for $3. Rather than an initial net debit, as is the case with the bull call spread, your client receives a net credit of $3 a share, which is the maximum profit should the stock be trading above $60 per share at the July expiration.
Note that the maximum potential profit from both spreads is $3 a share, but one transaction requires your client to pay money and the other allows your client to take in a credit. While there is no single correct way to play a bull spread, I have found that clients are more likely to maintain a position with a net credit rather than a position that requires the client to absorb a debit position.
Resolution 4: Limit orders only
A good rule of thumb is to use limit orders only when entering a new option position – especially if you are dealing with an illiquid market on a specific security. This resolution also follows in the path of prospect theory: a client is more likely to forgive a missed opportunity but lay blame for a bad position.
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