Long-time readers know I’m a fan of scaling in. I paid homage to the powerful tactic in a recent post titled The Lost Art of Scaling. I also mention it from time to time in the Options Report. Today I want to address an insightful question from Perla that will allow me to elaborate on the mechanics behind making the technique work. First, the question. Then, enlightenment.

Question about scaling in and out of positions with TOS (Coach TC’s strategy). For example, selling a naked put with the same strike price but at a higher premium. How do you buy back the naked put with the highest premium? When I select to exit the naked put with the highest premium, it buys back the first naked put entered. I contacted TOS about this and they said I can’t select which one to buy back. Any suggestions on how to scale out or should I buy back all at the same time?

Let me set the stage with an example. XYZ is at $50, has a bull retracement pattern, and is flashing a high IV rank. To capitalize you elect to scale-in to the July 45 naked put which is currently trading for 50 cents. Instead of plowing into a full-size of 3 contracts (let’s imagine that’s doable for your account size) right now at 50 cents, you are going to scale-in. Sell the first tier at 50 cents, the second at 75 cents, and the third at $1.00.

Obviously, the stock may not go against you enough (read: drop) to get filled on all three tiers, but imagine it does.

Now, you are short three $45 puts with each entered at 50 cents, 75 cents, and $1.00, respectively.

Here’s where Perla’s question comes in. As far as I’m aware, TOS uses a First-In-First-Out (FIFO) approach when accounting for your positions. That means the first put you sold will be the one closed out when you exit. I imagine your entry/exits like so:

Sell 1st put at 50 cents

Sell 2nd put at 75 cents

Sell 3rd put at $1.00

The stock finally bounces and the put value drops back to 60 cents.

1st put has an unrealized loss of 10 cents

2nd put has an unrealized gain of 15 cents

3rd put has an unrealized gain of 40 cents

At this stage I would typically buy back the 3rd put for 60 cents to lock-in the 40 cent gain. But, when you input an order to close one of your three naked puts, it closes the first one (FIFO, remember).

So, does that mean you locked in a 10 cent loss and not the 40 cent gain? Further, per Perla’s question, does it mean that to sell the 3rd put you have to essentially close all three options to realize the gain?

The answer is – it doesn’t matter. Don’t think about it this way. The truth is there is no difference between the first and third put. Or the second. See, put options, like dollar bills, are what we call fungible. One is no different than the other. The profit will come out the same whether TOS tracks the trade as if you bought back the first or third put at 50 cents.

I bet Perla is thinking of it the order of the transactions this way:

Sell 1st put at 50 cents

Sell 2nd put at 75 cents

Sell 3rd put at $1.00

Buy 3rd put at 60 cents

Buy 2nd put at 35 cents

Buy 1st put at 10 cents

However, TOS doesn’t let you do that! Fortunately, as I said, it doesn’t matter. I suggest thinking about it this way:

Sell one put at 50 cents

Sell one put at 75 cents

Sell one put at $1.00

You now have three short puts at an average credit of 75 cents.

Buy one put at 60 cents

Buy one put at 35 cents

Buy one put at 10 cents

All told, you purchased three puts at an average debit of 35 cents. That means your total gain is  $1.20 or 40 cents per contract.

Now, wasn’t that fun?