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BHI Credit Spread reversal for breakeven

February 27, 2007

At long last, the much mentioned post on the BHI credit spread gone bad, gone good.

But first, today’s market. WOAH, Bessie! What a blood bath! I hope everyone had their stops set out there. I’m not going to try to get into it, but looking at the weekly chart of the SPX, it looks to me like the uptrend is CLEARLY over and it would be very reasonable to look for a move back down to 1300 in the near future.

Now for the BHI trade. The purpose of sharing this is not only to show the possibility of “reversing a trade” when doing credit spreads, but also that it’s not quite so simple because there are further risks taken on when doing so.
One of the handy aspects of a vertical spread trade are that the maximum profit and maximum loss potential are clearly defined. On a 5 pt. credit spread, whatever credit you take in up front is your maximum profit and 5 – that credit is the maximum loss potential.
So you plan your position size for the amount of risk you are comfortable assuming. Let’s say your account size and your rules have determined that you will risk no more than $1000 in any trade. If you want to put on a Credit spread 5 dollars wide that brings in a credit of $1.30, you have $3.70 at risk. You can sell 2 spreads. 3.70 x 100 x 2 = $740. Selling that third contract would put you over the limit of your risk tolerance.

So you’re now comfortable within your risk tolerance and happy with the entry. The market or stock suddenly changes drastically and moves in the wrong direction. The magic line is broken, the position is turning into a loser and you no longer want to be in the trade. You can close the spread entirely for a loss, probably less than the maximum potential loss. You can hope it’ll turn around and start going in the right direction again(which is the choice we should NOT get in the habit of making – Say no to hopium), or you can try to reverse the trade.
Sounds complicated, but it’s not. You just buy back the short side of your credit spread. If you have a bear-call spread, you’ve sold a call and bought a call at a higher price. If you buy back the sold call, you’re now in a long call which is bullish. If you’re in a bull-put spread you have sold a put and bought a put at a lower strike price. If support is broken, you can buy back the short put and you’re then holding one long put which is bearish.
So the million dollar question has to be, “Has this new turn of events reversed my stance on this stock or index?” That’s a big call. In most cases, you will not go from bullish to bearish or vice versa. But sometimes you will. Drastic news and major volume can be very convincing for a decisive change.
But the trickiest part of all is that if and when you do decide to reverse the trade and buy back the short option, you have changed your risk exposure. In many cases, you will be opening the possibility to lose more money than you would have on the original max loss potential of the spread and certainly more than you would if you just closed the spread on the first break of the magic line or sign of major trouble.
Let’s look at my trade finally. (Somebody shut the guy up and show us some action!)
Here’s what the stock looked like as I was watching it for a move above resistance at 75.

It popped in a pretty convincing way over that level, but I didn’t catch it close enough to 75 to feel good about holding through a pullback to that level. With a potential play up to resistance at 90, the risk/reward is actually there for a reasonable trade to be made, but not for the risk I’m comfortable with options in my little account.

Watching for a pullback and successful test of support, I was satisfied with the next support on 12/28. The prior two days formed a Harami and the 28th was a higher day for confirmation. When I entered the trade, the stock was higher for a more convincing “higher” close than where it ended the day.

As discussed in this post on Dec. 28th, I entered a Jan 70/75 Bull-Put spread. Perhaps it was the potential weakness in the Oil Services charts(OIH), the whole market all together, or maybe that I just wanted a “conservative” trade, but I decided to do a bull put spread rather than a long call. The call would certainly have a much greater profit potential, but the bull put spread would have a higher probability of success since the stock only needed to close above 75 for the maximum profit.
I placed the trade in two accounts. One filled at a credit of $1.30, the other for $1.35.
On the Jan 3, the first trading day of the year, the trade went very wrong. BHI plunged through the 75 support area in a pretty dramatic way.

With one account, the more conservative one, I didn’t want to risk taking a bigger loss than I had to. So I bought back the whole spread. That one I sold originally for $1.30 on the 28th and bought it back on the 3rd for $2.95. A $1.65 loss not including commissions.
Here’s what I did with the spread in the other account.

Because the break was drastic enough for me to turn bearish on the stock, I weighed the possibilities and decided to “reverse the trade” to a bearish trade, buying back the short 75 put and holding on to the long 70 put. If you add it all up, you’ll see that in the end I made .05 or $5 dollars on the trade. Including commissions, it comes out to a loss of $1. Not bad. No big deal, right?
Well, consider the decision making process in reversing the trade. I could have closed the the whole spread like I did with the other one for a loss of about $1.60(since I got better fill to open this one). In reversing the trade, I bought back the 75 put, originally sold for $1.80, for $4.20. That locks in a loss of $2.4. But I am then still holding the 70 put that I paid $.45 for. So definite loss is 2.4 while the potential loss is still $2.85. Expiration is in 11 trading days and in order to come out at break even at expiration, I need the stock to be at $67.60 to assure that the intrinsic value of the 70 put equals the loss I took on the selling and buying of the 75 put.
Meanwhile, there is time value still left in the Out-Of-The-Money 70 put that is ticking away every day more and more.
At this point, all I wanted to do was break even and get
out. I added the loss on the 75 put to the original cost of the 70 put plus a little spice for commissions to come up with a limit sell order of $4.90.
Luckily the stock did continue to drop the next two days and my order filled on the morning of the 5th. It all worked out very nicely and seemingly easily, so of course I wished I had done the same with my other “conservative” account. However, the stock could have just as easily not continued down and gone back up or lingered between 70 and 75 while the unrealized gains on the 70 put were ticking away rapidly in time value. I would have then taken on a bigger loss than if I just closed out the whole spread all together in the first place.
Playing this game is very much like walking a tight rope. This one worked out for me. But I’ve definitely blown a few of these in the past. My impression is that more often then not it’s best to just close down the spread as one trade for whatever loss is there assuming it is less than the max loss on the spread. The probability oriented people at thinkorswim who almost exclusively sell time in the form of vertical spreads and others would not even think about doing such a risky and chancy maneuver.
Mike Coval and some Investools people will promote the great prospect of reversing a trade and make it seem easy. It’s not. It may be advisable to do in some cases, but my impression is that that it is usually not.
So there it is. My BHI trade. All that work, sweating, blogging and even your reading….just for a breakeven trade. I hope it was worth it. šŸ˜‰

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