In several of my previous articles, I have described a horizontal spread as one of my favorite strategies. At any given time, a horizontal trade is not the type of trade that can simply be placed and forgotten about. However, here was an instance when a trader did exactly that – he placed a trade and ignored it after it had gone against him. By the time I was contacted, the trade was in dreadfully bad shape. In fact there were two trades, one worse than the other. Let me start with the more difficult trade. The position was opened by purchasing the August long call, times ten. The cost of the transaction was 4.05 per contract and there were 10 of them.  (Note to self) It is not the best way to start learning option trading by going in with the platform’s default setting of ten contracts.  In all of my classes, I teach the concept of using a ‘foot soldier.’ Specifically, that means that I send a single contract to the market to find out exactly where the price of a specific option contract is trading. By always buying off the Ask and selling off the Bid the option trader always gets hit by the full amount of Bid and Ask slippage. I usually avoid full slippage by entering my entry as a LIMIT order at mid price between the Bid and Ask.

Moreover, I send in only one contract (one foot soldier to get killed) to get filled. After my order is filled at the price that I feel comfortable with, I send the rest of my troops in. These contracts are entered at a slightly adjusted limit price, for the markets are alive and they move constantly affecting the pricing of option premiums. This method of placing the trade at the entry was learned through experience and was not done by the trader mentioned above. He went all 10 contracts in at 4.05, which meant that he actually had a directional position on worth $4,050.  

Once the underlying security failed to move higher, he turned his directional option position into a horizontal spread position expecting the price to sell below his strike price at the July expiry.  For his trouble of turning the bullish trade into a bearish trade, he received 2.40 per contract. Once again, I emphasize the point that he did not enter this horizontal trade simultaneously, but waited for the market to go against him and at that point turned the position into a bearish one instead of closing it out. The $2,400 premium received reduced his initial debit amount to only $1,650. (The difference of the two amounts; 4.05 – 2.40.)  However, he locked himself into a position that he did not completely understand. 

By the time I had a chance to look at this position, the market was already ripping to the upside, which was indeed his original prediction. At that point his August calls were worth 5.79 while the July calls were trading for 5.15 and there were only two full trading days to expiry. If I were in that trade, I would have bought back my obligation; and sure enough later on I learned that the trader, out of desperation, acted the very same way and closed his sold July call.  

At first, the trade appeared to be a complete loser because he had sold the July for 2.40 times ten contracts, and had to cover it for 5.15 which produced a loss of 2.75 per contract. The August calls were left untouched and were closed only at the end of the day just before the market closed at its highs. The August calls that were bought at 4.05 were trading for 6.70, giving a gain of 2.65.  

In short, the trade played out for a small loss. He lost 2.75 on the July calls but made most of it back on the August calls for 2.65 after the underlying rallied almost 3%. His total loss on the trade was only $100 or ten cents per contract. Not a bad outcome for a trade that had an extremely grim outlook earlier in the trading day. 

In the second example, there were 12 contracts involved on a different underlying with the same strategy. The contracts for the August calls were bought at 3.39 while the sold options were at 2.84, reducing the outlay of capital only to the difference between the two at 0.55. The sold July calls were repurchased back for the cost of 4.55 for a loss of 1.71 per contract. The same scenario was followed for the exit as in the first example. The August calls that were originally bought for 3.39 were sold for exactly 5.00 giving a gain of 1.61. When the two amounts were combined (losing 1.71 from winning 1.61) the loss was only 10 cents per contract for $120 total loss because there were 12 contracts. The Figure below represents both of these examples in mathematical format.

This is an excerpt from Aug 2009 issue of Trader's Journal.