The Beauty of Locking in a Profit

In this article dated April 7, 2016, I wrote about a hypothetical option trading opportunity in MRK.  The gist of the idea was to “risk a little, in hopes of making a lot.”  Unlike many option trades that focus on using short-term options, this one used call options with over 6 months left until expiration – in order to give MRK a lot of time to stage some sort of move.

Well MRK moved and the time to “do something” appears to be at hand.

Figure 1 displays the initial trade and the initial risk/reward outlook.1Figure 1 – Initial MRK call backspread trade (Courtesy www.OptionsAnalysis.com)

Figure 2 displays the initial trade as of the close on 8/24.  As you can see, MRK stock advanced from$55.63 to $62.73 and the option trade was sitting with an open profit of $743 (+89.8%). 2Figure 2 – MRK call backspread as of 8/24 (Courtesy www.OptionsAnalysis.com)

The good news is that this trade has a nice percentage profit and retains further upside potential.  The bad news is that the trade could easily turn back into a loser if MRK stock backs off from here.  On 8/23 MRK failed to break out to the upside and the next day fell back hard.

So let’s consider a simple adjustment to lock in a profit while still allowing for further upside potential.

The Adjustment

The truth is that there are an endless number of ways to adjust any option trade.  The choice should be based on one’s outlook going forward for the underlying security in question.  In this case, I have no real opinion one way or the other regarding where MRK is heading next.  But I do know that I do not want to see the current open profit vanish, and I am willing to give MRK the opportunity to move higher still. As a result, the adjustment below involves:

*Buying 1 Oct2016 MRK 50 strike price call

*Selling 4 Oct2016 MRK 50 strike price calls

*Buying 1 Apr2017 MRK 65 strike price call

This adjustment simply exits the original trade and buys a single long call option that can allow us to make more if MRK does in fact move higher between now and April 2017 expiration (240 days from now).  The risk curves appear in Figure 3.3Figure 3 – Adjusted MRK trade (now long Apr2017 65 strike price call) (Courtesy www.OptionsAnalysis.com)

Things to note:

*This adjusted trade locks in a minimum profit of $523 if MRK is at $65 a share or below 240 days from now.

*The upside potential remains unlimited.

*If MRK rise 2 standard deviations (to roughly $83 a share, the profit can swell to $2,200 or more.

*If MRK collapses the worst case is still a locked in profit of $523.

Summary

One advantage to trading options is the ability to adjust your initial position in order to obtain a more favorable reward-to-risk ratio.  Hopefully this MRK example makes that assertion a little easier to understand.

Jay Kaeppel

 

2 thoughts on “The Beauty of Locking in a Profit

  1. Hi Jay, I have read your options guide book and i have a question to ask you. If i know the underlying stock or futures is expected to move but the direction is unknown then which options strategies i should use when the volatility is high and low. Thanks.

    1. If movement is expected, direction is unknown and implied option volatility is low then a long straddle (long call and put of same strike price) or long strangle (long call of higher strike and long put of lower strike) are viable options. If implied option volatility is extremely high then a reverse calendar spread (long shorter term call or put and short a longer term call or put of same strike price) can be considered. Note however that this strategy typically needs either a strong price movement and/or a sharp decline in implied volatility to generate a meaningful profit. Hope that helps, Jay.

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