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We have been discussing this past month the use of a bear call spread. However, after the stock rose unexpectedly, we decided to show a possible adjustment, which was to change the trade into an iron butterfly. However, since then the stock has gone even higher, right up to the edge of our stop-loss point. Below is the week-to-week data for this mock trade on Total SA (TOT).

02/07/2005
TOT @ 108.83
110-115 Bear Call Spread
Sell 5 Mar 110 calls @ 1.65
Buy 5 Mar 115 calls @ 0.45
Net Credit = $600
Max Risk = $1900
Breakeven = 111.20

02/14/2005
TOT @ 111.38
110-115 Bear Call Spread
5 Mar 110 calls @ 2.95 (ask)
5 Mar 115 calls @ 0.70 (bid)
Current Loss = 1.05 or $525
Net Credit = $600
Max Risk = $1900
Breakeven = 111.20

02/14/2005
TOT @ 111.38
110-115 Bear Call Spread Adjustment
Add a 110-115 Bull Put Spread
Buy 5 Mar 105 puts @ 0.35
Sell 5 Mar 110 puts @ 1.30
5 Mar 110 calls @ 2.95 (ask)
5 Mar 115 calls @ 0.70 (bid)
Net Credit = $1075
Max Risk = $1430
Upside Breakeven = 112.15
Downside Breakeven = 107.85
Current Loss = $575 (getting inside the spread)

02/22/2005
TOT @ 115.30
110-115 Bear Call Spread Adjustment
5 Mar 105 puts @ 0.05 (sell)
5 Mar 110 puts @ 0.25 (buy)
5 Mar 110 calls @ 5.60 (buy)
5 Mar 115 calls @ 1.95 (sell)
Net Credit = $1075
Max Risk = $1430
Upside Breakeven = 112.15
Downside Breakeven = 107.85
Current Loss = $850 (getting inside the spread)

We initially used a bear call spread on TOT looking for resistance at 110 to hold. It didn’t and we would have closed at the trade at this initial loss. However, to show a possible adjustment, we decided to convert the trade to an iron condor. What this did is increase our max reward, while limiting our max loss. However, we also need the stock to close as close as possible to 110. But, the oil stock has jumped this past week, closing Tuesday’s session at $115.30.

Last week we talked about not losing more than our max reward and using this loss exit, we are very close to closing the trade. However, getting inside the spread, we are currently sitting at a loss of about $850. Below is the risk graph for this trade as of the close of trading on Tuesday, Feb. 22.

Figure 1: Risk Graph for Iron Butterfly on TOT

Our upside breakeven on this trade sits at $112.15, with our downside breakeven at $107.85. Thus, we need TOT to drop below this point in order to not loss money on this trade. At the same time, the max loss would occur if the stock close at the upper strike price plus the credit received. Our credit was 2.15 per contract, so the max loss would be hit if TOT closed at or above $117.15 at March expiration.

Each trader has their own risk tolerance and exit strategies, but the key is to have a strategy and to figure out what exit points work best for you. Despite what happens in the weeks to come for this mock trade, we will track it just so our readers can see how the movement of the stock and time affect the spread.

As a trader, we also need to be able to analyze the current market to see what the environment is for the stock. In the case of TOT, it has been in a very bullish market this past week. Oil prices have skyrocketed and TOT has benefited. However, the stock closed well off its intraday high Tuesday even though oil prices moved to multi-month highs. This could mean that profit taking could emerge. At the same time, oil prices could be headed toward $60 and this would most likely create even higher prices for the stock.

Each trader will have a different take and this is why it is important to set up exit points and stick to them. What I feel might be a resistance point or reversal might not be where you think it is. Regardless, each trader should have plan their trade and trade their plan so that large losses don’t develop. We all will experience losses, but it is the trader that limits their losses and maximizes their gains that shows the largest profit at the end of the day.  

To read previous installments of Real-World Trading, please click here.

Jody Osborne
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
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