Losing trades can teach you more than winners

The Profile of a Losing Credit Spread

One of the first down gapper call credit spread trades featured in this column was Synaptics, Inc. (SYNA | Quote | Chart | News | PowerRating), which gapped down sharply last July following weaker than expected Q1 revenue forecasts. The computer touchpad technology company’s stock price dropped by $5.17, closing that day’s session at $15.85.

To take advantage of the weakness, a December 20 call was sold and a December 25 strike was bought as a cover, which created a vertical bear call spread worth $50 in premium, the maximum potential profit from this trade. As rule, I use a doubling of the spread value or the strike of the short option as stop loss points, whichever occurs first. I have emphasized these rules in previous articles.

In this case, the spread doubled on October 19, when it traded at $100, but the same day the stock price hit 20, as well, so the spread would have been closed with a $50 loss either. Figure 1 shows the price move that followed the positioning of this spread, indicating where the day the trade hit the stop loss point, and why it is important to follow these rules.

Figure 1 – SYNA spread price doubles on October 19, 2005, near a move back up to 20 area. Generated by OptionVue 5 Options Analysis Software

Taking a loss on this trade at the point of the spread price doubling to $100 makes a lot of sense, especially when you consider the value of the spread today with continued upward movement is $180, a much bigger loss should the position not have been closed.

This example illustrates the importance of risk management, and to keep trades well diversified to avoid too big a loss on any one trade.

Next week, I will take a look at one of our call backspreads that has not done so well in order to highlight again the importance of risk controls.

Cheers!

John Summa

John F. Summa is Founder and President of OptionsNerd.com, and a registered Commodity Trading Advisor (CTA) with the National Futures Association (NFA). Founded in 1998, OptionsNerd.com offers trading seminars and tutorials to options traders, futures and option trading advisories and managed futures and options CTA account services. Mr Summa's trading articles have appeared in Technical Analysis of Stocks & Commodities magazine, as well as Active Trader Magazine, Options Trader Magazine, Futures Magazine, Stock, Futures & Options Magazine, and Investopedia.com.

John coauthored Options on Futures: New Trading Strategies and Options on Futures Workbook (John Wiley & Sons, 2001) and more recently wrote the groundbreaking book, Trading Against The Crowd: Profiting From Fear and Greed in Stock, Futures and Options Markets (John Wiley & Sons, 2004), which includes Mr. Summa's innovative quantitative bear and bull news-flow Contrarian indicator. Mr. Summa is a PhD-trained economist and operates a delta-neutral options trading CTA program.