Question By Investpsych

Remedy for Losing Call Options Position?

What should we do when I buy a CALL Options (BUY TO OPEN) and stock is keep falling? I know I can have a stop loss based on my Risk profile and can SELL TO CLOSE that CALL Options. What all else I can do to protect(hedge) that investment? vice versa (for PUT OPTIONS)

Asked on 10 Feb 2012

Answered by Mr. OppiE

Hi Investpsych,

Indeed, stocks rarely go up the very moment you expect it to and some volatility before your prediction plays out is a very common occurrence. However, what happens during such temporary volatility is your leveraged position, such as options and futures, gets taken out by your stop loss in what is commonly known as a Whipsaw.

So, what can you do if you don’t want to have a strict stop loss in place which could lead to a whipsaw, at the same time reduce temporary account loss while waiting for the stock to go back in the direction you expect it to? (Learn more about the Six Directional Outlooks In Options Trading )

There are two things you can do actually; Write Options and Delta Neutral Hedging.

If you bought sufficiently in the money (ITM) call options, you could write Near The Money (NTM) call options, either slightly out of the money or slightly in the money, with strike price higher than the one you bought, transforming the position from a long call into a Bull Call Spread. As the stock declines, the gains on the short call options will partially offset the losses on the long call options.

Using Bull Call Spread as Remedy for Losing Call Options Position

Assuming you bought ten contracts of QQQ’s Mar $60 Call options when QQQ was trading at $63 for $3.10. Assuming QQQ drops to $62 and its Mar $62 call options are trading at $0.80 and your Mar $60 Calls are trading at $2.20.

To protect your call options by transforming the position to a Bull Call Spread, simply sell to open ten contracts of Mar $62 Call.

STO 10 contracts of Mar $62 Call = $0.80 x 1000 = $900 credit

If the underlying stock continue to drop, you could even roll the short leg down along with the stock in order to increase your protection.

Using Bull Call Spread as Remedy for Losing Call Options Position

Assuming QQQ continues to drop to $61 and its Mar $61 call options are trading at $0.60, its Mar $62 Calls are trading at $0.20 and your Mar $60 Calls are trading at $1.20.

To increase your protection, you could roll your short Mar $62 Call down to the Mar $61 Call.

BTO 10 contracts of Mar $62 Call = $0.20 x 1000 = $200 debit

STO 10 contracts of Mar $61 Call = $0.60 x 1000 = $600 credit

However, it is unlikely you can continue to write options with strike price lower than your long position without incurring margin should the underlying stock continues to go down.

The other, more complex, way of hedging against a losing call options position is by Delta Neutral Hedging. This means using instruments that contain negative delta to reduce the delta of your call options to zero such that the price of the resultant position will no longer react to small changes in price of the underlying asset. Instruments that carries negative delta include shorting the underlying asset itself, buying put options or even shorting futures.

Using Delta Neutral Trading as Remedy for Losing Call Options Position

Assuming you bought ten contracts of QQQ’s Mar $60 Call options when QQQ was trading at $63 for $3.10. Assuming QQQ drops to $62 and your Mar $60 Calls are trading at $2.20 with a delta of 0.8. Assuming the Mar $62 Puts are trading at $1.10 with delta of — 0.5.

Total delta value of call options = 0.8 x 1000 = 800