Updated: Aug 6, 2019
After having sold our options, we immediately prepare for exit strategy execution when the trade turns out much better or worse than we anticipated. One of them is called the unwind exit strategy which - when implemented impeccably - is going to put a lot of cash into our pockets. This involves closing our short put position in order to free up lots of capital to then enter a completely new trade with the SAME cash in that SAME month. So, we can make two income streams. In this article, let's dive into a real-life trade I made with Galapagos, a biopharmaceutical company with a thriving pipeline so that you can learn all intricacies associated with this exit strategy.
The technical conditions were favorable at that point in time.
I usually trade the stock on Euronext Amsterdam, where there's ample liquidity for options trading. With shares trading at €112.80, the €108, €110 and €112 strike prices proved to fit my system requirements. To keep the math simple, I'm using 1 contract now.
On average, these trades would return a very nice annualized return in excess of 40%. That's too hard to ignore, isn't it? :-)
But there's even more: exit strategies to take your profits to even higher levels and that is exactly what I did just a few days after having executed the trades highlighted above.
When the price of the underlying securities popped up sharply to more than €122.12, the puts we sold had become worth less even despite the fact that we were still early in the contract.
So I bought back the option since there was very few time value to be collected and with over 19 trading days, I re-entered a completely new trade. Let's take a look at how the calculations play out and how should analyze them.
Closing the €112 would result in a REALIZED return of 2.99% since the option value decreased to 15.19% the original value we received. My guideline to buyback an option when the share price moves up dramatically depends on whether the return lost is reasonable to make up for. In order to frame our objective within appropriate rules as to when to close out our trade, I would say a time value cost/cost-to-close of less than 1% is a reasonable percentage to quit the trade. In case of the €112 put, the cost-to-close (the return we REALLY LOSE) is 0.54%.
Closing the €110 would result in a REALIZED return of 2.35% since the option value decreased to 11.60% the original value we received. In case of the €110 put, the cost-to-close (the return we REALLY LOSE) is 0.31%.
Closing the €108 would result in a REALIZED return of 1.60% since the option value decreased to 8.95% the original value we received. In case of the €110 put, the cost-to-close (the return we REALLY LOSE) is 0.16%.
Before moving forward with the unwind exit strategy, you have to be able to find other candidates that meet your system requirements AND are very likely going to deliver a return which exceeds your cost-to-close.