49.75, theold Chinese curse has come true, for we are now living in interesting times.From a profitability standpoint, we’re again better off than we were at the20-day mark. The 48-strike puts are likely trading between 125 and 155 pointsby now. Our two defensive puts are around 370–400 and 200–220, respectively; in short, our open loss is approximately 180 points plus 7 commissions, $860 or thereabouts. Even though our situation is unfortunately“interesting” (we want our positions to be extravagantly boring when wewrite options), we have a dandy little edge on our side. With time having become so short in the life of the options, each passing day or any sort ofbounce upward in the market price, even 100–200 points, will eradicate greatchunks of the remaining premium remaining in the price of our short puts.Please pardon another mild digression. Observe that, to get to this point,we have made entirely negative assumptions about market movement.We’ve postulated here that this trade has gone just crazily wrong. The hypothetical behavior of the gasoline market in this example is, frankly, aberrant, although it might of course occur. We’ve assumed that HUK has movedessentially straight down for 54 days . . . a pretty rare occurrence. It’s evenrarer, much rarer, to see a qualified non-seasonal trade become a one-way
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market in the contrary direction. Notwithstanding all this negativity, ouropen loss is small, certainly less than our original intended profit, which westill may very well earn.In plain English, we’ve kept the probability of success on our sidethroughout by applying a reasonable defense to the trade. No genius in it,no “boy, are we lucky,” none of that—in fact, we’ve been quite unlucky. Wehave simply behaved in a practical manner. Wouldn’t you consider that thisresult to date isn’t far better, no matter how it ultimately turns out, than ourhaving let the other traders reach into our pockets by passively accepting aloss earlier in the trade? We’re still heavy favorites to end up with theirmoney in our pocket, are we not?So, how does the trade finally turn out? Choose any outcome you like.If the market moves up, goes nowhere, or moves moderately lower into expiration, we clearly end up with a profit. We may have to repurchase theshort 48-strike puts below 48.00 if the market moves there, or they may justexpire quietly. We’ll sell back the defensive puts we purchased wheneverwe consider doing so to be to our advantage, probably at the same time weresolve the 48-strike puts. Better still, we have excellent chances to be profitable on both the puts we sold and the puts we bought. Consider whathappens if, on expiration day, the market price is right where it is now, or100–150 points lower. Run the numbers—you’ll be quite pleased.One way or another, even though the original trade has gone verywrong, we are still highly likely to end up with the other trader’s moneywhere it belongs . . . in our pocket. In four of five cases from here (sharplyup, up, nowhere, down), and in the three most probable (up, nowhere,down), we’ll show a profit. Indeed, in two or maybe three of the cases, we’llend the trade with a greater profit than we anticipated when we entered it.I won’t speak for you, but as far as I’m concerned, this is an excellent result,even if the fifth case comes along.In the fifth case, a sharp drop from here, we can still very easily end upon the plus side of the ledger if we’re alert, although we may have to waitanother month to pocket the profit. “Huh?” I hear you saying, “If HUK dropsanother 500 points from here in 6 days, you’ve got a major problem, there’sno way to escape a big loss!” Oh, really? Care to bet on that (he asks withan evil grin)?Who says that a defense must end coincidently with the end of the original trade? Nobody, that’s who. We have at least two perfectly satisfactorytactics available to evade such a loss or convert it into a profit, if we wishto employ them. “We ain’ takin’ no steenken loss on thees trade, señor” . . .and certainly not here and not yet when excellent and useful tactics for retaining profit still exist, and the expectation of our position is still very positive. Let’s examine this notion of extended defense.
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The Roll-Out and the Flip—Not So Fast, Jack,It’s Still My MoneyOne tactic we might employ in an extended defense is the roll or roll-out, astraightforward, intuitively appealing tactic that has been thoroughly discussed in the literature on option trading. In its basic form, a roll consists ofrepurchasing the options we originally wrote, and then writing one or moreoptions of the same series (puts if we originally wrote puts, calls if we wrotecalls) that expire in the next month, or even 2 or 3 or more months furtherout. The striking price of the options we’ll write, or roll into, may or may notbe the same as the strike we originally wrote and subsequently repurchased.The flip is the other side of the roll, the converse tactic. We put it intopractice exactly as we do the roll-out, except that we write the opposite series from the options we originally wrote and repurchased, writing calls ifwe originally had written puts and vice versa. As a practical matter, goodopportunities (by which I mean statistically favorable ones) for a flip defense seem to occur less frequently than they do for a roll defense. There’sprobably some perfectly good reason for this, but I’m hanged if I knowwhat it is.An example of a straight roll-out defense might occur in the Canadiandollar. The “Loonie” has been weak for a number of years and has been afavorite of some traders for writing calls. Suppose we wrote the February63.00-strike calls on March Canadian dollar (ticker symbol CDH, but the option’s symbol is CDG) when CDH was at 62.20 on January 4. Suppose it subsequently moves to 62.95 with just 2 or 3 days left in the life of the option.We should have a look at rolling our option write into March.Suppose we wrote the CDG 63.00 calls for 18 points and they’re now at17 (typical premiums, by the way, just what they actually were in 2002).This current price for our options is ho-hum normal, even after CDH hasmoved almost to our striking price, because these options have become extremely short-dated. We might buy them back and roll into the March 63.50calls. The 63.50 strike is the next higher striking price available, and let’ssay these calls are at 22 bid/25 offered. Alternately, we might just repurchasethe CDG 63.00-strike calls at a tiny loss, trading costs included, call it a day,and look for something more profitable to trade. Which course we take willdepend on current market indications of whatever kind we favor and anhistorical evaluation of CD’s movement over the next month. Similarly, fora roll defense in our HUK example, we’d buy back the 48-strike puts andwrite some number of WOOM June unleaded gasoline puts. We might selectone of the 43-, 42-, or 41-strikes, depending on current premiums and the results of the new historical and expectation analyses we will surely performbefore taking any action.
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Choosing Our Defensive TacticWhich strike and which month we actually do elect to roll into or to flip intowill depend on the relative level of advantage we can observe for the optionsunder consideration. There are a few preconditions for and tactical pointsin implementing either a roll-out or a flip defense, and these apply withoutregard for the strategy we employed in the original trade.1. The historical tendency of our option’s market over the next period must
not be notably in the wrong direction, must not be up if we’re rollingcalls or flipping puts, not down if rolling puts or flipping calls.2. Present day supply/demand considerations, insofar as we can tell,should not indicate that our market is likely to move toward the strikewe’re rolling or flipping into.3. Roll-outs and flips must always be at a credit, net of costs. We must sellmore premium than we repurchase.4. In the best case, the time remaining in the life of the option we’rerolling out of or flipping out of should be as short as possible.5. In the best case, we prefer to apply a roll or flip defense for exactly onemonth, with the clear realization that this may not always be possible.6. Both our bid to repurchase the written option(s) and the subsequentoffer when we write the option(s) we’re rolling or flipping into shouldbe to the offer side of the bid-ask spread.7. The striking price of the option we’re rolling or flipping into should beas far away as possible from the striking price of the option we’re repurchasing, consistent with maintaining an acceptable ROC, even if thisrequires us to write more options than we’re repurchasing.If we’re rolling out of a short call option position and our market historically tends to move higher during the next month (assuming we’re rollingout just the one month), we’re thumbing our nose at the market, in effectdaring it to come and get us. This action is plainly wrong-headed, becauseit will, it will. There is no good reason to violate condition 1. If you want toshow your machismo, go run with the bulls in Pamplona next summer;you’ll save money. This is the spot for a flip defense.The same sentiment applies to condition 2. Traders seem in my experience to err regarding this condition most frequently when writing puts inagricultural markets during or just after a good harvest. Seasonal tendencies aside, when a good crop is coming in (or has just finished coming in),it’s very difficult to estimate how far the market price may drop. Why shouldwe bother trying? We might get it right, but are the odds of our doing so
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highly favorable? Hardly. In these situations, again, I strongly advocate thatwe opt for a flip if we intend to extend the defense.Condition 3 is vital. Once more, time is money, and if we’re going to sitin a trade for another month or more, we must absolutely insist on earninga profit. We will roll out and/or flip only at a net credit, always and everytime, or else we’re kidding ourselves. Here’s a proposition for you: wouldyou like to enter or continue a trade with exactly zero possibility of (further)profit, but some measurable probability of loss? Right, you wouldn’t thinkof such a thing—but that’s precisely what you’re doing if you execute eitherof these defenses at a net debit. Don’t do this.Condition 4 is variable. The shorter-dated the option is when we repurchase it, the better the result of our defense is likely to be, because our favorite ally, Sister Theta, will be doing a number on its time premium. Perhapsa more important question is at what point to elect to roll out or to flip. Ina straight WOOM option write, how close should the present market pricehave moved to the striking price of the options we’ve written? This is wherepersonal taste enters the picture. I use a very arbitrary rule of thumb, andI’ll warn you right now that it’s too conservative, or seems to be. It’s effective enough, but I’ve ended up wiping egg off my face any number of timesby having to sit in a trade for another month when, as things turned out, nodefense was necessary. That’s right; a little egg never hurt a professionalcoward.Subtract the closing market price on the day you wrote the option fromthe option’s striking price. Make this a positive number if it is not (take theabsolute value). Divide it by the number of trading days remaining in theoption’s life on the day you wrote it. Call this number A. Then, from tonight’sclosing price, subtract the option’s striking price, and take the absolute value.Divide that figure by the number of trading days remaining and call thisnumber B. Multiply B by 1.36 and call this C. If C is less than A and there areless than two weeks remaining in the option, defend the trade with a flip ora roll, which one to use being dependent on your market view for the nexttime period. If more than two weeks remain, consider a hedge defense instead, if feasible.Yes, you will defend more WOOM option writes than you might do otherwise. Yes, you will curse at me once in a while for initiating a defense,only to find that the market suddenly stops threatening the trade and youget to sit for an extra month or two and only earn a diminished ROC. Andyes, when a trade continues going wrong in the original direction, you willprotect your trading capital, retain good chances of profiting ultimately,and undergo one heck of a lot less aggravation. I told you before that I’m aprofessional coward. We cowards have one outstanding trait: we sleep verywell at night.
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The fifth condition is a trifle obvious. By defending for a single month, wegenerally obtain the best value on the per-month time premium of the optionsinto which we roll or flip. Caution considerations, and the illiquidity or nonexistence of the next month’s options, may dictate that we move out furtherthan one month, and that’s perfectly acceptable. If a two-month defenseusing a more distant strike increases our expectation of ultimate profitabilityin defending, we should be perfectly willing to accept a lower per-monthROC. This trade-off, caution versus ROC, appears constantly in option trading, and I’ll take the more cautious stance or action every single time.Condition 6 is subtler. If we decide to apply a roll-out or flip defense,the first order of business is to buy back the short options, and we shouldbe rather eager to get this business done. To this end, if the market for ourstrike is quoted at 30 bid/50 offered, we should probably make our first bidat 45, or even 50 if this market’s options are thinly traded. If you happen notto be in a hurry, then by all means bid 40, even 35, but how is it that you’redefending this trade and are simultaneously not in a bit of a hurry? Soundsa little inconsistent to me.Contrarily, having repurchased the threatened short position, we canand should be a little patient when we offer the options into which we wantto roll or flip. If their market is 90 bid/115 offered, then our (first) offer shouldbe 110, or perhaps 105, but somewhere above the midpoint of the bid-askspread in any event. If there is any volume at all in the strike we’re trying toroll or flip into, we should have good chances of being filled toward theoffer side of the bid-ask spread. We can always lower the offer later if ourorder isn’t filled.If the market moves away from our offer, which it will do some percentage of the time, shrug it off. That’s life, that’s the market. Absolutely, we detest such a result, but the market dictates to us, not the other way around.We’ll charge it off to experience gained, and the next time we’ll be a bit moreaggressive in implementing a defense. Even if we can’t complete the defenseand are dollars out-of-pocket, we still have benefited by exiting the losing/threatened position. Our trading risk no longer exists.The final condition may at times be a little awkward for us, but be assured that I did not write it down for practice, because it’s nearly vital. Letme emphasize once more that we only defend a trade if the market’s movement has demonstrated that our original market analysis, whatever kindwe performed, was wrong. The roll-out defense and the flip defense both require a market view. We wouldn’t be defending the trade unless our previous market view has been proven inaccurate. We must therefore recognizethe possibility that our second market view may be every bit as incorrectand compensate for this possibility by rolling or flipping into options whosestrike is as far away from the current market price as is possible and thatmeet our other criteria.
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By rule, we must write more premium than we repurchase, and, especially in a declining market, obeying this condition will occasionally requireus to write a larger number of options when defending than the number werepurchased. This requirement is yet one more reason why we must keep acomfortable capital cushion in our trading account at all times: we mightneed to commit part of our current free capital during a defense.
Defense Is Rarely PerfectReturning to our earlier HUK example, we see that we can—for the immediate term—dodge the potential bullet of a further sharp drop in the price ofHUK over the remaining 6 days of the trade by either rolling or flipping. Whatwe’d rather do is to wait a day or two and let theta chew up as large a chunkas possible of the remaining premium in our short puts. Therefore, becausewe have the enormously potent ally of time immediately on our side, weshould at least try to sit still for a bit. The merest upward move will solve ourmodest dilemma swiftly and handily. Even a couple of days of the HUK market doing nothing will put our trade right back into the profit column.I’ll save you some time here. It’s a blue moon when expectation, ROC,time remaining in our current short options, the market’s distance fromthe striking price we originally wrote, and the next period’s historical tendency all fall into line for a roll or a flip defense. We’re back to, sigh, approximations. Said another way, we will accept the best arrangement we canfind that encompasses these factors to the best degree possible . . . or we’lluse a different defense, or we’ll fold the trade and take the loss. Our usualtools, the computer and the spreadsheet, will help to inform us which ofthese actions is likely the most advantageous. Our object in an extendeddefense is to reduce immediate risk and to maximize the range of profitability in our altered new position. Clearly, we must compare the relativeexpectation of sitting in our present trade to that of shifting to the new position and remaining in the market for another 30 or 60 days.When we’re examining the desirability of applying a roll or a flip defense,it’s a given that our original market view has been proven incorrect by themarket’s actions. When we apply one of these defenses, we are in the generalcase stating that our analysis won’t be wrong twice hand-running, or threetimes, or four, or even more. Roll-out and flip defenses can be implementedany number of times, sequentially, until we finally cash out or dispose of theentire position. It’s both somewhat costly and very aggravating to have torepeat a defense, though, and I’ll leave the question of whether to undertakemultiple sequential defenses to your good judgment. If we can manage towhittle the loss in our position down to some very small level or to sneakback into the profit column, the intelligent and efficient thing to do is to endthe trade right then and find something more profitable to trade.
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All the tactical points relevant to the roll-out defense apply equally to theflip defense, except one. Applying a roll defense to written calls in strongishor developing bull markets is problematic. We might, by using the supply/demand or technical indicators we favor, be able to detect the possibility ofthe bull market becoming a runaway market, but we have no guarantee whatever. Holding a short call position when a market threatens to or actuallydoes go berserk to the upside, a recent instance being 2001 January naturalgas in December 2000, can and usually will seriously damage our tradingcapital. Therefore, we should adopt the policy of being relatively more conservative in selecting OOM calls to roll into when the market shows morethan a modest bullish inclination. We’ll miss an occasional fine defense, butwho cares? We’ll also avoid being strung up by the ankles when the bulls gocrazy.
Defense Is Not a Boxing MatchWhether we’re using the non-seasonal or other option writing strategies,and no matter with a bullish or bearish stance, it goes without saying—or itshould, but I’m going to say it anyway—that we don’t want to put ourselvesin the position of fighting the market. I don’t suppose you and I would everdo this voluntarily, but we might accidentally get thrust into such a positionif market conditions change rapidly after we’ve entered a trade. In our continuing HUK example of a longer-dated WOOM option write, we initiated ahedge defense when the market had moved roughly one-third of the distancebetween the market’s price when we entered the trade and 48.00, the strikeof the put we wrote. Are we fighting the market by doing this?No, we’re not. We’re a little suspicious about why the market is behaving in the fashion it is, to be sure. We’re distinctly worried about a furtherdecline, too (or else we wouldn’t have defended the trade), but our principalreason for entering the trade, its non-seasonal tendency, is still completelyvalid at our first defense point. When it comes to the second defense, buying the 50-strike put after the tendency has been violated, a case could bemade that we have begun fighting the market to some extent. You can getinto very interesting debates on this topic, but I’m of the view that the seconddefense is a perfectly reasonable action. Why? We are now in doubt about themarket’s short-term direction. To address this concern, the second defenserepresents net risk reduction for our trade over either direction the marketmight move during the next short period of time. Yes, we will cost ourselvessome money if HUK turns back higher, but we can control this loss closelyin almost all cases. What we can’t do, and absolutely don’t want to do either,is expose ourselves to excess (or “gigantic,” choose your favorite adjective,just don’t choose “unlimited”) risk in the downward direction, which outcome can occur if we refuse to undertake a second line of defense.
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Combining Two Defensive TacticsWhen defending, we aren’t in any way bound to a single defensive tactic.Many times, two different defensive tactics can be combined quite usefully,or a second tactic can be employed to enhance the first defense after thefact. A combination defense that frequently offers us excellent capability isthe application of a roll-out and a flip simultaneously. I call this a “fission”defense because it resembles what occurs when a neutron splits an atom.Suppose we’ve written OOM options in a relatively high-volatility marketwhose options are fairly or very liquid. Suppose also that the market movesin the undesirable direction for our purposes, and time is running out on theoptions but the market is threatening our trade. Whether or not we have already undertaken a defense for our trade isn’t relevant here; maybe wehave, maybe we haven’t. This is probably a fine spot for a fission defense, andyou’ll find a detailed example of the application of this defense in the realworld a little later, when I’ll be inviting you to “Pay Me After Lunch” inChapter 13.
Spreading—How Accurate Do You Wantto Try to Be?When we apply a hedge defense to a written option position, we are actuallyengaging in a form of spread trading. We’ve written some options, we’ve purchased some others against them, and this is the basic definition of a spread.Spreading or, more precisely, conducting a price arbitrage between two related markets, has been a popular strategy for a very long time, dating backat least to the Dutch tulip mania centuries ago.Spreading is easy to employ as an offensive strategy. We might come tothink that, due to summer weather developments or for other reasons, August soybeans will gain in price relative to November beans, and we’d therefore buy the August contract and sell short the November contract againstit. We might believe that the price differential between British Royal Dutch(Shell Transport) shares and Dutch Royal Dutch shares will change, andtrade accordingly. Right now, however, we are concerned with the notionof spreading as a defensive tactic if one or another of our option positionsbecomes threatened, or when a position becomes profitable and we want toprotect our gain to some extent.A spread defense for written options that involves buying options inother months than the month of the options we wrote is difficult to use, barring pretty specific conditions. If we buy the same number of options in afurther-out month than we originally wrote in the (presumably) nearby
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month, we convert our original net credit into a net debit, usually an impermissible action for a first defense, and we also sharply reduce our range ofprofitability.I will only employ this kind of spread, called a time spread or calendarspread, for defense if two separate conditions exist. We want the optionswe originally wrote to be very short-dated, to have a very short time untilexpiration, and we insist that the IV of our written options be much higherthan the IV of the options we purchase for defense, 15–25% higher or more.Even when the market meets these conditions, we’ll be taking on a gooddeal of risk of an unfavorable market move. If we apply a spread defenseand the market moves sharply against the defensive long side of the trade,we may not have any means to recover the loss. We will be in a position,again, of hoping that subsequent market movement will be in our favor.If we buy fewer options in the further-out month than we’ve written inthe near month, in order to keep our position at a net credit, this is a betteridea. If, also, the IVs of the short options are well higher than the IVs ofthose we purchase for defense, we might end up doing very well for ourselves, converting our temporary loss into a nice profit if the market tradesin a moderate range until the short-dated options expire. Our plan here is tosell back the options we bought if the market stops threatening the strike ofthose we’ve written, and to sit still if the market persists in its threat. Thisis still far from an optimum tactic, though, because in many cases we maybe required to keep adjusting our position as the market bounces around,as a rule much more frequently than when adopting a hedge defense. Whendefending, the more trading decisions we make, the lower will be our ultimate profit, almost all the time. Write it down.We could take a more exotic stance regarding spread defense, say, by examining diagonal defenses or delta/gamma-neutral defenses. What are these?These are tactics we retail traders want to avoid using, that’s what they are,and, no, I’m not going to discuss them here. We can only manage these typesof defenses successfully if we’re willing to monitor our trade more or lessall day every day, and likely make lots more trading decisions. More work,more contest risk, and probably less profit? Uh, gee, no thanks. We don’tneed to make life so difficult for ourselves. In defending written options,avoid a spread defense in favor of a roll or a flip, or of accepting a loss whenit’s modest, unless the IVs of the options you intend to purchase are waylower than the IVs of those you’ve written. Problem solved.Institutional traders are able to apply complex spread defenses forwritten options if they wish, because they have the computing power, thelower trading costs, and the personnel resources necessary to manage thesedefenses successfully, at least in a statistical sense. You and I do not enjoythese advantages. Go ahead, try a spread defense one time, under less thanthe precise conditions mentioned previously, when you’ve written some
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option(s) and the position becomes threatened. You’ll soon see what I mean,if it’s not already very clear.
Moving the Goalposts—Difficult but EffectiveThere’s one last general defensive tactic to examine. Opportunities to applyit are somewhat scarce, and it embodies a little more risk than we’d usuallyprefer to accept. However, when we observe a situation where a market hasmoved against our position in a written option and other defenses are unavailable or undesirable, this defense is highly effective in reducing a lossor in returning our trade to profitability over time.Suppose we’ve written an option and the market moves adversely. Suppose also that we don’t want either to roll the short option out or to flip itinto the next month. There are a number of situations in which we mightprefer not to adopt an extended defense. The next month in our chosen market might involve some large weather risk, as in summer coffee or grains.Equally, we might be aware that the next month is historically much moreauspicious for buying options than for writing them, as, for example, if wehad written August CME/IMM currency options and it became necessary todefend the position. Moving the goalposts is a good way to reduce the immediate threat to our trade, regain most or all of any paper loss we might have,and possibly return to profitability . . . and all within the same time frame asour original trade.There are two ways to apply this tactic, which I call respectively “thesingle” and “the double.” The single move-the-goalpost defense consists ofrepurchasing the options we originally wrote, and for each repurchase writing two or sometimes three options whose striking price is further away fromthe current market price, but having the same expiration date. The doubledefense consists of repurchasing the options we wrote and then writing twoOOM strangles (see Chapter 9) for each option repurchased, again with thesame expiration.The operational preconditions for moving the goalposts, as far as I understand them, are:1. Other defenses aren’t suitable to our current position and situation, or
their preconditions cannot be met, or they are undesirable for marketspecific reasons.2. The IVs of the options in this market at this time are not at the low orthe high end of their 6-month range.3. In the single version of the defense, we must be able to replace the premium we repurchase by writing no more than three options further away
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from the market. In the double version, we must be able to replace thepremium repurchased by writing no more than 2 OOM put-call pairs(strangles), and we must make the width of the strangle (the strikingprice of the call minus the striking price of the put) as wide as possible.4. We do not, ever, extend when we defend. We only move the goalpostsin the same expiration month as the original option we wrote.5. We prefer that the time remaining until expiration be short, but, in extremis, moving the goalposts is acceptable as a defense in a longer-termtrade. In a longer-term defense, we will strongly prefer the single defense to the double.A good example of a move-the-goalposts defense occurred in one of myaccounts in April–May 2001. On April 16, for what seemed like very goodreasons at the time (cough . . . an optical illusion that I was too nearsightedto see through), I wrote several June coffee put-call pairs (ticker: KCM) thatwere to expire on May 11. I chose the KCM 55.00 puts and 67.50 calls, withJuly coffee (against which the June options offset) trading at 60.15, andreceived 110 points gross for each put-call pair. Coffee, although a longstanding bear market at the time, had indicated that, heading into summerand hence the usual possibility of weather dramatics, it had stopped goinglower for a while at least.That indication was proven out pretty quickly. Two weeks later, Julycoffee touched 65.00 cents and closed just under that, at 64.45. When itopened above 65.00 the next day, it was clearly time to defend, given thatthere were 101⁄2 calendar days and 81⁄2 trading days left until the options expired. I had zero intention of rolling the June calls into July or any othermonth. One freeze event in coffee equals three strikes and out, possibly outforever. Nor did I want to flip the calls into July puts, because in most years,when Brazilian coffee doesn’t freeze, it moves well lower from mid-May onward. The market was within one striking price of the calls I’d written, sono hedge defense was possible. The IVs of the market weren’t suitable fora time spread defense. This, my friend, was a dandy spot to try to move thegoalposts. The “double” version looked particularly attractive.I repurchased the 67.50 calls for 210 points apiece (very ugly!) andwrote in their stead the 72.50 calls for 80 points