IWM Diagonal Spread Update

Our entry on this IWM diagonal spread and protective put ratio backspread option trade was premised upon a continuation of the stock's bullish trend.  With the stock no longer following that trend, the underlying basis of the trade is no longer present.

May 18, 2006 - The Stock Market Has Dropped On Increased Volume Over The Last Two Trading Days, It Is Now Time To Re-Evaluate Our Option Position.

Everything had been going quite well with our combined bullish diagonal spread and protective put ratio backspread trade.  We had entered on a swing low and watched the market and IWM trade higher, then pause near the strike of our short call option.  With a little more than a week left until expiration, we were looking at a near maximum profit if things just stayed where they were.

The market never rests, however.  On Thursday, May 11, 2006, the market dropped hard on increased volume.  The small cap index and IWM followed suit, dropping from the opening price of $76.75 to close at $75.31. 

On Thursday evening, I looked at this position and decided to place an order to buy back the single short  put.  The closing quote indicated that I could repurchase it for .40, which was 50% of the credit I had originally received.  What this would do is provide additional protection to the downside, should the market continue to fall.  A risk graph of the contemplated adjustment demonstrates this.

I was hoping to see a slight bounce on Friday morning, but the bears remained in control. 

The order to re-purchase the short put did not fill and the value of the short call dropped to .10, providing no benefit.  When the short option loses 80% of its value due to market movement, my plan requires that I close the position and evaluate a roll out to the next month. 

On May 12, 2006, the short May 77 call was closed for .10 and the June 76 call was sold for a $1.10, resulting in a net credit of $1.00.  The debit on this trade was further reduced.

The adjustment had the effect of tightening up our exposure, but also reduced the maximum profit of the trade.  By May 16, 2006, it was apparent that IWM was no longer trending within our anticipated range.  It had broken through the lower standard deviation channel line and on May 17, 2006, IWM was trading outside of the projected probability cone.

Because IWM was no longer trading as we had anticipated, there was no sense in staying with the trade.  The decision was made to close the position and move onto another opportunity.  The diagonal spread was closed for a credit of $640 and the put ratio spread was closed for a $105.00 debit. 

Date	Position	Cash Invested
April 17	BTO 2 IWM Aug 72 Calls STO 2 IWM May 77 Calls	$930.00
April 24	BTO 2 IWM May 72 Puts STO 1 IWM May 74 Put	$0.00
May 12, 2006	BTC 2 IWM May 77 Calls STO 2 IWM Jun 76 Calls	($200.00)
May 17, 2006	BTC 2 IWM Jun 76 Calls STC 2 IWM Aug 72 Calls	($640.00)
	BTC 1 May 74 Put STC 2 May 72 Puts	105.00
	Total Capital Loss	$195.00

Not every trade is going to be profitable.  When the market or underlying stock does not move as we anticipate, our goal is not to turn a losing trade into a winner.  Rather, once our trade is open our responsibility is to be an effective risk manager.  This trade resulted in a $195 loss, which is easily recovered from.  The reason the trade was closed was because it had become obvious that IWM was not continuing on its bullish trend and that the premise upon which we entered the trade was no longer applicable.

By limiting your losses through responsible money management or risk management, you will preserve your capital and keep yourself in the trading game.  Also, by limiting your losses you give your profitable trades the opportunity to offset the loss and generate overall longer term profitability.

Good trading!

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