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DTV Trade

January 19, 2007

It’s pretty rare that a trade using the Investools arrows just jumps out at me. Well, this one did. I anticipated the official green arrow on the MACD, but it was pretty certain to come the next day. Volume spike was icing on the cake. But most of all, I liked that there wasn’t problematic looking resistance and it was still close enough to the MA to use that as support.
Here’s what it looked like the day I entered the trade.
(To see it bigger…say “open sesame.”) ( and then click the image)

This was a paper trade. The idea was to ride the trend until it ends. My risk allowance in this paper account is 1 to 2K. I would use the MA as support and set my initial stop at 3% below the MA. That would be about 21. The end of day purchase price would have been 22.4. So the risk in the trade would be 22.40 – 21 = 1.40. My position could be established so: Risk allowance of 1000/1.40 = 714. I’d round it to 700 so I could do covered calls if I wanted to since options contracts deal with round lots of 100. This stock trade would require $15,680.

But I wanted to do a longer term option trade to particpate in this trend. So I chose an ITM option with plenty of time, the March 17.70 calls. With $4.90 of intrinsic value, the option costing $5.40 had only $.50 in time value and a very high delta, so this was very attractive to me. Because it was deep enough in-the-money and with a very high delta that it moved virtually dollar for dollar with the stock, I could work out the risk and position virtually the same. 1.40 risk in the set-up divided by my $1000 risk allowance comes to a rounded 700 just like before, but with options contracts in lots of 100 I would by 7 contracts. Remember that I said 1-2K was my risk allowance, so to keep it a nice round number, I bought ten contracts, still well under the 2K risk.
So, on 11/21, I bought 10 March 17.5 calls at $5.40 for a total of $5,400.
To do the equivalent upgrade to the stock purchase, that would have been 1000 shares costing $22,400 in total.
I was very pleased, of course to see the jump the next day and a just a few days of hesitation before powering higher.
You know how I like my support and resistance, so I drew lines around what looked like a clear channel. With that, I was not surprised to see the price take a pause when it hit the channel resistance on Dec. 11/12. I was happy with my profit but wanted to ride out the trade. However, it looked like a period of sideways action was a distince possibility. In order to squeeze a bit more out of the trade during this sideways action, I decided to “cover” the position by selling the Jan 25 call on 12/14 for $.95.

I of course faced the risk of being “called out” and having to deliver stock on my obligation as a seller at $25. But this would have been a very nice profit I’d have been happy to have. I could have used my 17.5 calls to buy the stock at 17.5 and then deliver it at 25. That is a difference of 7.50, and subtracting my net debit on the options positions (5.40-.95=4.45) I would have a net profit of $3.05 when all was said and done. Not bad for an initial investment of 5.40. However, that was just the reasoning behind selling the call. I was capping the profit potential, but if called out it would have been a 56% return on investment(before commissions).

Part of the plan was to let the short Jan 25 call tick away its time value and potentially buy it back cheaper and uncover the long calls for the stock to bounce up off channel support. All the while, I would get out of the whole position on a break of support.

The stock did move sideways and time ticked away. As it approached the channel support line, I put in a limit buy order to buy back the 25 call if it went down near the horizontal support line that had formed. It filled on 1/5 buying the 25 call back for .25. I was ready for another bounce up, but 1/9 the stock broke horizontal support, the channel support line and even breached the MA for a third red arrow, so I sold the calls for 6.65.

Here’s what the trade summary looks like.

Total Credit at the end of these four trades is 1.95. So for ten contracts of 100 shares each, the profit is $1,950. Commissions cose $24.95 for each leg, so a total of $99.80.


Option Trade.
$1950 profit minus commissions of $99.80 = Net profit of $1850.20

  • 34% return on the investment of $5,400.

Stock trade (would have been)
$1740 profit minus commissions of $30 = Net profit of $1710

  • 7.6% return on investment of $22,400.

Though approached in a quite conservative way with no more risk built into the trade, the Option trade cost less than 1/4 of the stock trade, but made more money.

This is a good trade and I’m pleased with how I played it. However, I realize that I would have been more profitable buy just selling the initial call when it hit the channel resistance. Perhaps that is what I should have done. But since I wanted to ride the trend, it was right to not sell it. That was the plan. Since the trend was still very healthy and I had months of time left in the option, that was okay to stick with.
What is more important, is whether or not it was worth it to cover the position and cap upside gains potential for the purpose taking in a little premium on the 25 call. It’s debatable, but I think in hindsight it wasn’t worth it. If the stock had shot higher, I would have lost out on a much bigger gain. I did get .50 out of the sideways and downward move toward support before buying it back, but that didn’t compensate well enough for the profits I gave up when the stock fell through support to feel that great about the idea. Simply put, the gain from the short call did not justify the risk of missing out on a much bigger gain.
If the way to make big money in the market is buy cutting losers short and letting winners run, legging into diagonal spreads or covered calls and capping gains is going to mess with that notion helping our accounts. Nothing wrong with spreads or covered calls, it just comes down to how you plan to trade consistently over time and what works out to a profitable expectancy you are happy with. Again, it comes back to the importance of a plan, what you intend to do and how.

I’m glad I did this review. It was very helpful to me to realize that this legging into spreads stuff isn’t always as rosey as it sounds. Mike Coval pushes this kind of stuff a lot and I find it intellectually a very interesting challenge, but for its complexity including a great deree of relying on time decay (rather than just taking your profit when you see it) I’m not so sure it’s always the right thing to do. In this case, it wasn’t. I should have just stuck with the straight call and played it just the same minuse the short call.

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