for the move to reverse itself. If she didn’t have the trade on now, would she
sell ten 65 puts at 1.07 with Johnson & Johnson at $65? Based on her
original intention, unless she believes strongly now that a breakout through
$65 with follow-through momentum is about to take place, she will likely
take the money and run.
Stacie also must handle this trade differently from Brendan in the event
that the trade is a loser. Her trade has a higher delta. An adverse move in the
underlying would affect Stacie’s trade more than it would Brendan’s. If
Johnson & Johnson declines, she must be conscious in advance of where
she will cover.
Stacie considers both how much she is willing to lose and what potential
stock-price action will cause her to change her forecast. She consults a
stock chart of Johnson & Johnson. In this example, we’ll assume there is
some resistance developing around $64 in the short term. If this resistance
level holds, the trade becomes less attractive. The at-expiration breakeven is
$63.25, so the trade can still be a winner if Johnson & Johnson retreats. But
Stacie is looking for the stock to approach $65. She will no longer like the
risk/reward of this trade if it looks like that price rise won’t occur. She
makes the decision that if Johnson & Johnson bounces off the $64 level
over the next couple weeks, she will exit the position for fear that her
outlook is wrong. If Johnson & Johnson drifts above $64, however, she will
ride the trade out.
In this example, Stacie is willing to lose 1.00 per contract. Without taking
into account theta or vega, that 1.00 loss in the option should occur at a
stock price of about $63.28. Theta is somewhat relevant here. It helps
Stacie’s potential for profit as time passes. As time passes and as the stock
rises, so will theta, helping her even more. If the stock moves lower (against
her) theta helps ease the pain somewhat, but the further in-the-money the
put, the lower the theta.
Vega can be important here for two reasons: first, because of how implied
volatility tends to change with market direction, and second, because it can
be read as an indication of the market’s expectations.