XLE Option Assignment Case Study

This was a long trade. Maybe not the longest trade we've been involved in, but certainly one of the longest as this short put option assignment lasted over 5 months. For most options traders looking to make a quick buck, this trade stretches their patience and conviction far beyond a reasonable level. Still, I think that today's case study is important to hear because it proves critical concepts to how we think about trading here at Option Alpha. And, what better way to prove something than to show you how we managed the entire position, start to finish, with real money.

XLE Case Study

The original position, a simple iron butterfly in XLE, was entered on 10/11/2018.
The day we entered the position, XLE had already fallen in two days from a high of $78 to a low of $72.68.
As a result, implied volatility had spiked to about 100%.
We decided to open up a single contract at the time.
We sold the $73 calls and $73 puts, buying options out on either end by a couple of dollars. For the wings of this iron butterfly, we bought the $79 calls and the $66 puts.
The position resulted in an overall net credit of $365.

Early Assignment

In this case, we got the "direction" completely wrong. The price of XLE the day we entered the position was actually the highest price XLE traded throughout this entire trade.
On November 9th, we were assigned the stock for November expiration.
At this point, the stock was at $66, putting our short option position very deep in the money, triggering an assignment.
We were assigned 100 long shares of stock.
At this point, we still have all of the other components of the original iron butterfly position.
We decided to hold the assignment and manage the position.
As we got closer to November expiration, we had the opportunity to sell back our $66 long put option.
The $66 long put option started to go into the money, and we sold it back to the market for $57.

Credit Calculation to date:

Original position - $365
Selling the $66 put option - $57
Total credit now = $422

November Expiration

XLE was trading at $66, the short put option strike price.
We decided to continue the position and hold onto the long shares.
Everything else we had for the original November position expired worthless.
At this point, the stock is trading at $66, so we tried to reduce the cost basis by selling a covered call.
After expiration, we sold the December $70 covered call on our position, which gave a decent premium (87 cents) and also left some room for the stock to rebound.
We sold the next monthly expiration--so about 30 days out from expiration.
Total credit now = $509

XLE Goes Down, Again

A week later, XLE moved from a high of $68 to a low of $54 the day before Christmas.
We've now held the stock for 3 and a half months, while it has taken a nosedive twice.
At this point, the stock is really oversold, but our breakeven point has been moved down to $67.91.
We believed that the market had gone down too far, too fast.
On 12/4, we decided to roll down our short call options.
We bought back our $70 strike calls and rolled those down to the $68 strike calls to collect additional premium.
As the stock moved lower, we got an opportunity to move down our calls and collect additional premium (a net difference of $51)

December Expiration

In the middle of December, the stock continued to nosedive, and as a result, IV spiked.
As we approached December expiration, we decided to roll out our covered call position from December to January.
We used a diagonal order to move the covered call from December to January while changing the strikes.
We bought back our December $68 call options and sold the January $67 call options for an additional credit of $50
Total credit now = $610

January Expiration

We held the long stock position for yet another month.
The stock rebounded to a high of around $62 as it reached January expiration.
The $67 call options expired worthless.
We were once again left with a simple, long stock position in XLE.
On January 31, we decided to sell the March $67 call options for 43 cents (additional net credit of $43).
Total credit now = $653

Approaching March Expiration

Fast forward a month and a half to March 12, 2019 and the stock had only gone up about $1.50 during this entire time.
At March expiration, XLE had still not breached the $67 short call strike.
So, we continue to stay the course!
We bought back the March $67 call options for 2 cents, and rolled out to the $66 call options in April that were trading at $1.04. The net credit on the roll was $102.
Total credit now = $755

April Expiration

We had an opportunity on 4/05, as the stock moved a little bit higher, to remove the entire position for a net profit.
We sold back our entire covered call position for a $65.63 credit.

Position Summary

Let’s review the P&L on the trade:
Total credit of $7.55 - $73 cost of assignment = Net cost basis of $65.45 per share
On 4/05 we sold the position at $65.63.
$65.63 sale of the position - $65.45 cost basis = $0.18 per share profit
Total profit = $18

By no means is this a great profit, but it could have been much worse if we had not decided to keep our position size small, to keep selling premium, and extend the duration to reduce our cost basis. If we had reached our breaking point and capitulated on the trade at the lowest price, our ~$66 cost basis would have turned into a roughly $1,300 loss.

Conclusion

You can take a seemingly small position, and it can become a very large loser. That is why position sizing is so important to begin with.
For many people who got into this trade, the position ballooned so big that it reached their breaking point of no return.
If you have enough patience and fortitude to stick with it and reduce the cost basis and hold onto the position for potentially 5 months, when it goes against you, you can turn it all the way back around.
The key is to do the mechanics right, stick to the rules of position sizing, and manage your portfolio balance and total capital allocation.
For another example, listen to EWZ Short Put Option Assignment Case Study.

Option Trader Q&A w/ Robert

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today's question comes from Robert:

For a small account, would you recommend trading the weekly $1 or $2.50 spread with liquidity in the triple digits on both strikes instead of a $500 spread with good liquidity? Where do you think is the line in the sand you shouldn't go past on liquidity? Could you run into issues with the triple-digit liquidity if you're just trading a couple of contracts?

Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.