Reducing Risk In Our Stock Option Trading With No Cost Insurance

Over the weekend we took a look at a couple possible adjustment to our IWM diagonal spread. Our diagonal spread was opened and had turned profitable with an upward surge in the underlying stock. We looked at adjusting the position to reduce risk and capture or enhance profits.

$930.00

Our opening transaction created a debit of $930.00, plus commissions. This also constituted our maximum risk on the trade. Our put ratio backspread was opened for a zero debit, as the sale of the 74 Put option covered the cost of the two 72 Put options.

A Protective Put Ratio Backspread

A put ratio backspread opened for a zero debit creates a trade with a small range, between the short and long strikes, where we might see a loss. There is zero liability to the upside and unlimited profit potential to the downside.

Combined With The Diagonal Spread

When combined with our diagonal spread, our profit potential to the upside is fully preserved because the zero dollar put ratio spread adds no cost to our position that would otherwise place a drag on profits. However, the maximum downside risk is curtailed substantially. Recall that we had a maximum risk of $930. The risk graph now reveals a maximum risk of about $471.

Contemplating A Bear Call Spread

We also took a look at opening a vertical call credit spread, or bear call spread, as a way of enhancing profits and reducing our positive delta. That adjustment would create the potential for a small loss to the upside, but it also further reduced our risk of downside loss. The net effect was that the cost of the trade would be reduced by the amount of the credit, the maximum loss would also be reduced by the amount of the credit, but we would not have unlimited room on the upside for profits.

This credit spread was not opened because with Monday’s fall in prices an acceptable credit was not available. This position may be opened at a later time, but we are running out of time in May and it is still too far from June’s expiration to contemplate a next-month spread.

Option Trade Management Plan

Absent a large downside move in IWM, the plan is to simply sit tight. Our risk has been mitigated through May’s expiration and our upside profit potential remains in tact. As we near the May expiration, we will begin looking at our next possible adjustment to the position. That adjustment will most likely see us close the short 77 Call option and roll out to the next month for a credit. This will enhance profitability and reduce our trading risk. If we are not able to roll the short call for an acceptable credit, the position will likely be closed.

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