Salvaging a Bad Options Trade

I started trading options about one year ago. In that time, I’ve traded plenty of out-of-the-money, at-the-money, and deep-in-the-money options, all depending on my time horizon and goals for each trade. I’ve certainly had my share of losing trades as well as some profitable ones. More important, I’ve learned an incredible amount about how options work and how to trade them, all while slowly becoming more comfortable with the incredible speed with which the value of options can change. When thinking about this volatility, I now definitely feel that taking profits on a trade is never a bad thing, even if the value of the position continues to increase after I exit the trade, because the position could move in the opposite direction just as easily.

I recently had an options trade that quickly became one of the worst trades I have made over the past year. Although I don’t have many years of experience with options, I have quickly learned that there are some key circumstances under which the probability of a successful trade is very low, regardless of my personal sentiment toward the underlying company. If I had thought this trade through, I would not have entered the trade to begin with, but I did because I reasoned that the stock had moved too much, too fast. However, the market did not agree with my position (and neither did I after a very short period of time), and I found my position rapidly trading at a pretty big loss.

In February of this year, Panera Bread Company (PNRA) posted good quarterly earnings but issued weaker forward guidance for the first quarter of 2014 (which the company attributed to the inclement winter weather). Panera’s stock initially dropped overnight, but it opened at $172.91 the next morning, just under the $173.18 price that it had closed at before the earnings were released. Shortly after the market opened, Panera’s price began to steadily increase and was up over 6.5% by the afternoon (reaching $184.48). I felt that this up move was a little too much given the poor forward guidance and that the stock would likely give back some of its gains before the close of trading that day. So I decided to buy (go long) a March monthly $175 strike put option position for $3.20 to try and capture some gains from the stock selling off a small amount at the end of the day. The stock actually did give back some of its gains and closed at $179.56 (which was still a nice 3.8% gain for the stock on the day). At that point, although my put option position was not in-the-money, the option value was actually higher than when I had purchased it because the underlying stock had decreased in price, so I could have sold my put option position for a gain. However, I didn’t sell the position because I wanted to see if the stock would drop in price a bit further the next day. That did not happen, the stock gained another 0.5%, and I still didn’t sell my put option position. The following day, Panera’s price continued to increase and reached a high of $185.28. Soon, the value of my put option position had dropped all the way down to $1.20, which represented a loss of over 60% in 3 days.

Since I entered this trade solely as a short-term position, I should never have let the trade get away from me like it did. For a number of reasons (which I will explain below), I probably should have sold the put option the day that I bought it (regardless if I had a loss or a gain) rather than holding on to the position in an attempt to make a bigger gain. However, given that I didn’t do this, as a learning exercise, I decided to try and see if I could salvage a bit of my loss. To do this, I averaged down by buying more of that same original put position but at a lower price and by buying another put of a higher strike price (specifically, the March monthly $180 strike put). By doing so, I was able to decrease the average price of my put position to $1.92 from the original $3.20. I held this put position over the next several trading days and closely watched the movement of the underlying stock, waiting to get out of my put at the first sign of any weakness in the stock price. About one week later, the stock did drop below $180, albeit very briefly (it closed over $180 that same day), and I took the opportunity to sell my put position at $1.55.

Even though I was able to salvage the trade somewhat and exit the position with an ~19% loss, I should never have entered the trade (or held longer than intraday) because I picked the wrong stock, more specifically, the wrong type of stock, to try and get a gain off of by playing its fade after weak guidance. First, Panera is a stock with a relatively low amount of overall shares – it has about 27.67 million shares outstanding and a tradable float (which is the number of outstanding shares minus the number of restricted shares, held by insiders like company executives) of about 25.6 million shares; this is a small amount of available shares compared to Apple’s 860 million outstanding shares or Facebook’s over 2.5 billion outstanding shares. In addition, Panera usually trades with pretty low volume – only 675,000 shares are traded each day (about 2.4% of the overall outstanding shares on a daily basis). Of its 27.67 million outstanding shares, about 8.5% (or about 9% of the stock’s float) are held short (meaning a bet that the stock will go down and not up). On top of all of this, 89% of the shares are owned by institutions (such as banks and mutual funds) and insiders, not individual investors.

Overall, investors have differing opinions on what these numbers mean for a particular stock’s future and whether or not it is a good investment to buy (e.g. some investors believe high institutional ownership is good because it shows a high level of professional demand for or interest in a stock and may indicate longer-term stability, whereas others believe that when institutional ownership gets too high, it may indicate a top in the stock). However, when taken together and analyzed with the stock’s recent price action in mind, you can get a little better idea about how a stock might act and affect a derivative position (e.g. my put option). Interpreting these numbers on my Panera trade: the tradable float was small, the short interest was reasonably high (not over 10% but definitely not negligible – enough to squeeze the stock a bit), and the institutional ownership was very high. So when the stock did not sell off much after its initial bounce after earnings, that should have been a pretty clear signal to me that the institutional investors were not dumping the stock and that there likely was not going to be enough selling pressure in the very short-term to bring the stock down and allow my long put option position to be profitable. In fact, there definitely was a good deal of buying pressure instead.

All in all, this was a bad trade, but I wanted to discuss the trade in detail so that everyone could see how quickly options positions can change and the risk that they involve. However, this is part of buying out-of-the-money options; you cannot be correct all of the time, and you will have some very bad trades. As options are leveraged, when they go down, they go down fast, but they can also go up very fast as well. The key is keeping your trade size small so that when a position does decrease in value or even become worthless (which happens with out-of-the-money options as their value decays with time due to theta decay), that decrease or loss only accounts for a very small percentage of your overall portfolio.

1 Response

  1. scott says:

    Hey Johnny,

    Thanks for the excellent article! I’ve been trying to think through the process of averaging down (it is a little confusing because I’m not entirely used to working with options, let alone put options). I’ll have to devote more time after the exam.

    I did find an interesting article which describes the process of repairing call or put options: http://www.investopedia.com/articles/optioninvestor/05/030105.asp

    By just buying more options didn’t you significantly increase your risk? Would rolling the position into a put spread or butterfly spread, as discussed on the above site, been ways to do it as well?

    Also, you mentioned that Apple has 860 million shares outstanding. Just think how many shares there will be after the 7:1 split!

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