I stumbled upon some good fortune this week in my management of a bear call spread. And since this is the first time I think this particular outcome has ever happened, I find it incumbent upon me to record my adventure for posterity’s sake. I have to leave some gems for my grandkids to read-up on while learning how to trade at the wee little age of 5.
That’s when trading school officially begins in the Craig clan.
On October 26th things were getting dicey in small-cap land. Despite a valiant defense, buyers were unable to defend a pivotal support level. Fearing for the safety of my unprotected short puts (the Nov 114’s to be exact), I swiftly added Nov 125/128 bear call spreads for 29 cents credit.
Sure enough, those dastardly bears pressed their advantages driving IWM dangerously close to my $114 strike. Worse yet, it was the eve of Election Day; the final chapter of a bloody battle between a crooked donkey and a bombastic, wicked-tongued elephant. What I did with my naked put is a tale for another time. Today’s hero is your grandpappy’s deft management of the bear call.
The IWM plunge brought swift gains to the Nov 125/128 bear call. And as is my modus operandi, I was looking to exit stage left with profits in tow. But, as I was reaching for the exit button on my keyboard, inspiration struck!
To fully appreciate your crafty grampy, let’s first make sure you understand the usual approach for entering and exiting a bear call spread. At trade entry, I sold the Nov 125 while buying the Nov 128 call for a net credit of 29 cents. That 29 cents represented my max reward and would be captured provided IWM sat below $125 at expiration. Rather than always riding to expiration I typically look to buy back the call spread for a few pennies to lock-in the gain and free up my capital for other trades.
To exit the trade I would buy to close the Nov 125 while selling to close the Nov 128 call. At the time I was planning on exiting, the call spread was worth a scant 2 cents. To exit, I would have bought back the Nov 125 call for 3 cents while selling the Nov 128 call for 1 cent.
Now, here was the inspiration. Why sell the Nov 128 call for 1 cent? After commission that transaction would be a net loser (paying $1.25 to sell a call for $1.00 = you’re a dummy).
Rather than closing the long Nov 128 call, I simply bought back the Nov 125 call for the 3 cents. At the time IWM was perched at $118, so the Nov 128 call sat $10 out-of-the-money with nine days remaining. I considered it a lotto ticket sitting in my back pocket just in case the Market Gods decided to reign down glory and sunshine on one as good-looking and deserving as me.
Then, magic happened. The crooked old donkey got spanked by the elephant. And against all expectations the stock market soared to the moon taking IWM along for the ride. And guess what? Those 128 calls that sat at a scant 1 penny last week, now stand tall at $1.54.
Read that one more time to let it sink in. From 1 penny to 154 pennies in a week! Insanity, kids. Insanity.
Of course, I didn’t ride it all the way up. I was happy enough when the $1 in the calls turned to $25. I jumped ship like a bumbling fool (non-greedy pig?) at that point.
Moral of the Story:
If the long call in your bear call spread is already close to worthless. Don’t sell it. Simply buy back the short call (that’s the one that has risk anyways) and then pray to the market gods for an insane up move so you can bank some coin on your long call. 99% of the time it’ll probably end up expiring worthless. But, boy-oh-boy, the 1% of the time can get eye-popping.
The same could be applied to bull puts.