Markets don't sleep. But you do. And like all traders on earth, you go to sleep innocently, hoping with every good intention that once your head hits the pillow, the world economy will behave itself until you’re back at your trading screens. It’s not too much to ask, but the markets are rarely so accommodating. Consider three of the biggest things causing sleepless nights for traders.
1. Big Overnight Moves
While you sleep, suppose a German banker makes a big media splash with a rate announcement. Or a Chinese bureaucrat decides to get creative with his country’s economy. Six degrees of separation (at most) means we’re all connected, and you might wake up to a wild and crazy market—with a trade on that might not line up with all the excitement.
Even professional market watchers can’t predict what can happen overnight to the U.S. market. Chances are, if you’ve been at this trading thing for a while, you don’t really fear market events or news. But you might be worried about the size of the loss that could occur if overnight action causes the U.S. market to move against you. The bigger the potential loss, the less of a morning person you become.
One solution? Make the potential loss smaller. For example, maybe you’re long stock. If a big move lower on the open might create a loss that looks too big for your account, don’t sit there worrying. Get your hedge on.
For long stock, buying a put is a classic hedge. The long put is a type of protection against a drop in the price of the underlying. And somewhat like an insurance policy, the more protection you want, the more you’ll pay. The loss on long stock can be offset; when the price drops, the value of the long put increases. But the further out-of-the-money (OTM) the put is, the slower the put rises when your stock drops. The lower the put’s strike price, the greater the potential loss on the long stock before it increases in value. The higher the put’s strike price, the smaller the potential loss on the stock before it increases in value.
All things being equal, the put at the higher strike has a higher purchase price (cost) than the put at the lower strike. Calculate how much protection you want, and how much you want to pay.
Or maybe instead of long stock, you have a naked short put. Even a cash-secured short put can take a big loss if the underlying stock drops sharply. If you buy a further OTM put in the same expiration as your short put, you’re creating a defined-risk short put vertical spread. No matter how far the stock drops—even to zero—the loss on the short put vertical is limited to the difference between the strike prices.
2. Married To a Loser
Sometimes you love a stock too much, even as the price is falling. A small loss on long stock can turn into a bigger loss. And a bigger loss can turn into something that messes with your happy breakfast smile. No strategy guarantees that the loss on a trade can be erased. But you can feel more in control if you act. The max possible loss on a long stock position is the price you pay for it. So, the less you pay for a given stock position (its cost), the less its max possible loss.
How to Sleep with a Loser: One way to reduce the effective cost of long stock is to sell covered calls against it. For example, if you pay $50 for 100 shares of stock, that’s $5,000 you’re spending (before commissions). If you sell a 52-strike call for a 0.30 credit, that’s $30 of cash that goes into your account (before commissions), which brings your net cost to $4,970. If the calls expire worthless, you still have 100 shares of stock and can sell another call. Repeating this process can steadily reduce the effective cost and risk of the long stock. Keep in mind that doing this consistently may be difficult to reproduce. But what if the stock has already dropped from $50 to $40? True, selling a call against it caps its upside potential if the stock rallies back. It’s also true that the stock might continue to drop, or maybe just sit there at the lower price. In those cases, selling a call to reduce the effective cost can still make sense. And if the stock price does rally above the strike of the short call, you can either roll the call to a higher strike, or let the long stock be assigned and take a somewhat smaller loss. A smaller loss is better than a bigger loss, and it helps you still feel some of the old affection for the markets even before a massive dose of morning Joe.
3. Assignment Is Near
The dread of being assigned on a short option is always there (See "Demystifying Assignment" below). For example, if you’re assigned on a short put, the resulting long stock position may have a margin requirement that’s too big for your account. If you’re assigned on a short call on a dividend-paying stock, you might have to pay that dividend. But you might be able to anticipate if and when options might be assigned if you know the economics behind it all.
Crunch Your Numbers: To figure out the likelihood that a short option might be assigned, put yourself in the shoes of a trader who’s long that option. For instance, if you’re long a call, you have defined risk, and you can only lose as much as you paid for the call. If the call is on a stock that pays dividends, you’re not eligible to receive that dividend unless you own shares of the stock. Furthermore, the cost of the call is often less than the cost of 100 shares of the underlying stock. The smaller cash outlay for the long call means you can still earn interest on more cash in your account.
If you’re long a call, then you could exercise it and get long stock. This can mean three things:
1. You can receive the dividend on that stock if you own the stock before ex-dividend date.
2. You’ll pay, or lose, interest on the amount of cash it took to buy the stock at the strike price.
3. You’ll enter a stock position that has a larger potential loss than the long call if the stock price goes to zero.
Is the dividend enough to cover the interest lost or paid, and the cost of buying the put at the same strike as your call? But why are we looking at the put? Well, if you buy that put, it hedges your long stock, and replicates the risk/reward profile of the long call you had before you exercised it. Thus, the decision to exercise depends most heavily on the dividend.
Now, if you’re short a call option that’s in-the-money (ITM) and are concerned about assignment, consider this course of action:
1. Calculate the interest component by multiplying the short call’s strike price by the three-month T-bill rate, and then by the number of days to expiration, divided by 360.
2. Add that interest rate component to the price of the OTM option at the same strike as the short call.
3. If the ex-dividend date is between the present and the call’s expiration, and the dividend is larger than the interest plus the price of the OTM option, it can mean assignment is more likely. If that’s the case, you may want to close the short call before the stock’s ex-dividend date, or roll it to a further expiration, where assignment is less likely.
Finally, take a look at the Risk Profile of your positions on the Analyze tab of the TD Ameritrade thinkorswim® platform. This will show you the theoretical profit and loss of a trade across a range of stock prices, and can help take the guesswork out of risk management. You can even see the beta-weighted risk profile for your portfolio on the Analyze page.
Use your tools, protect your trades, fear not the dark night, and join the ranks of happy morning people.