Tuesday, May 24, 2011

Mitigating Losses in an Option Position

Options are often known for increasing leverage with limited risks. However, losses are losses. Because options are less frequently used than equities, people often feel that there is nothing they can do when a uni-directional option bet does not go the way they have intended. In fact, they are many ways to mitigate losses or even sometimes to turn losing positions into profitable ones. The following is one of the many scenarios:

1. Losing position: Long VIX 20 call at $1.75. Currently, VIX is $17.80
2. Old cost: $1.75
3.Trader's new expectation: The market may not be as bearish as expected, VIX may not jump high.
4.Mitigating losses: Sell 2 VIX 20 call at $1.50 and buy 1 VIX 16 call at $3.00
5. New position: 1 VIX 20 call and 1 VIX 16 put (A bull spread)
6. New cost: $1.75 (incurred by the old position) and zero for the new position.

The new position has lowered the breakeven point from 21.75 to a much lower point at 17.75. VIX does not have to rise as high for the trader to break-even. On expiration day, if VIX closes at $18.50, the trader will have a small profit of $0.75 instead of a loss of $1.75 if he had stuck to his initial position. Note that this strategy is best applied with the new position incurring little to no cost other than commissions.

Hope this helps. Please feel free to comment if you have any other strategy to mitigate/reverse losing positions. For more details on option strategies, I find "Options as a Strategic Investment" by McMillan quite useful. It is much more practical than John Hull's " Options, Futures and other Derivatives".

Click on the image to review the book

No comments: