Hello TEBers! In this post we will discuss an example of rolling out (and up) a credit spread on Mallinckrodt (MNK) that I initiated a week ago. The quote by Jesse Livermore pictured above is fitting as time really is your best friend when it comes to credit spreads.
For those who don’t know the definition; a credit spread is involves a purchase of one option and a sale of another option in the same class and expiration but different strike prices. Investors receive a net credit for entering the position, and want the spreads to narrow or expire for profit.
On Monday Oct. 12 I entered a 65.5/68.5 Bear Call Credit Spread using the October options on MNK, which paid a credit of 1.13 per contract. The options were set to expire that Friday, the 16th.
The goal of this option spread is to see MNK close at or below 65.5 on the expiration date so the options expire worthless and I keep the 1.13 credit.
Come Oct 16 MNK was higher than 65.5. In fact, it had a strong up move with the market that day and was up at 68.
The question became, do I take the loss and move on or do I roll the option spread allowing more time for the trade to work out for me.
I decided on the latter.
With MNK trading around 68 I looked at the OCT Week 4 and OCT Week 5 options. Though the week 5 offered more profit potential, given that there is two weeks of time premium in there as opposed to one, I decided to go with the Week 4s.
Remember, with options, as a seller time is your friend because the implied volatility is something that will shrink as the option gets nearer to expiration. Hence, the value of Jesse Livermore’s quote; time really is a speculators best friend.
Now, since I decided I was only going to roll the spread out one week the next decision was strike price. Do I stay with the 65.5/68.5 or do I roll it up to get a little closer to the current price?
I decided to roll up one strike to the 66.5/69.5 bear call spread. It provided a net credit of .45. So essentially what I did was close out the 65.5/68.5 (and technically take a loss on it) and then open the 66.5/69.5 and receive net credit of .45
The net credit equals the credit amount I took in on the new spread less the loss I took on the previous spread.
So now my profit potential is .45 per contract if MNK closes at or below 66.5 come Friday, Oct 23.
Some traders may agree with this trade and some may not. In the end, an individual trader’s risk tolerance, profit expectations and idea on the given stock dictates which decision is right for them.
Credit spreads give you a 2 in 3 chance of making money and I decided to take those odds a second time even with the reduced profit potential because my idea on the stock hasn’t changed. However, I wasn’t willing to commit to that idea two or more weeks out, so decided to go with a shorter time frame that also came with the smaller profit potential.
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