Steve,
Are you suggesting if you have put the back spread on (in say the LeapFrog (LF) example), you would sell, say, September calls (in money or out of money?) if the position quickly moved into the money, but keep the short October 15 calls and long October 25 calls? When would be a good time to close the short October calls?
-- L.R.

The reader is referring to a suggestion in

Wednesday's column of establishing a back spread (a back spread consists of being long more options than you are short in the same underlying stock using the same expiration date) in some beaten-down stocks. But before looking at the numbers and possible positions adjustments, let's clarify that the suggestion in that column was to use options with a January expiration, not October. As I wrote, using a longer-dated option first and foremost allows the position to realize a gain at lower levels, and taking a profit should always rank high when considering what to do next.

Sticking with our prince of a position, LeapFrog, the first item to note is that October options are not yet listed and won't come on board until the August options expire today. November's will be listed when September expires. (Some of the listing procedures and their effects on trading were addressed in today's

Readers Forum.)

So the first lesson to be aware of is the specific issue's options cycle, liquidity and other items that might eliminate potential trading opportunities. Of course, the underlying stock can always be used to lock in gains and as a relatively low-risk means of capturing short-term trading profits through the process of

shorting common shares against call options.

Since Wednesday's column was written, shares of LeapFrog have gained 6.4% to $19.10, and the January back spread (short one $15 call/long three $20 calls put on for even money) already has a small credit balance of 80 cents. Although it's probably too soon to lift off or make any adjustments, it's heading in the right direction.

Compare this with how the shorter-dated options responded. The same back spread using September expiration is showing a loss as the position went from a net credit of 20 cents on Tuesday to a net debit of 45 cents (on Friday the September $15 call was trading at $3.90 while the September $20 call was still worth only 50 cents) even as LeapFrog shares gained. This highlights the impact of time decay and the risk of being caught in the "dead zone" between strikes when back-spreading with short-dated options.

Let's Play Pretend

Before looking at a hypothetical price scenario and possible adjustments or trading strategies, let's assume that the original back spread was established by selling five of the January $15 calls and buying 15 of the January $20 calls. While this was still done for money, be aware that the maximum loss is now $2,500 should LeapFrog be at $25 at the January expiration. But that's a long way off, so instead be optimistic and assume that LeapFrog shares hit $20 on Oct. 1.

Sticking with the current implied volatility of 44, the January $15 and $20 call options would have theoretical values of $7.80 and $3.80 per contract, respectively, giving the total original position a value and profit of $1,800 ($5,700-$3,900). But more importantly, the position's delta has increased to 6.8, opening up a variety of opportunities.

Assuming the above price of $22.50 per share on Oct. 1, here are just some of the ways to get the position back to delta neutral and their implications going forward.

Sell eight of the November $20 calls for $3.50 per contract for a total of $2,800 to secure a $300 profit while maintaining some upside profit potential. The maximum loss had been $2,500, but you have now taken in $2,800 of premium. If LeapFrog is below $20 per share at the November expiration, those options expire worthless and you still will be holding the original January position and the opportunity to sell December calls. This is an example of what the article meant by suggesting "selling shorter-dated options to take advantage of their accelerated time decay."

The above also keeps in mind the other and most important maxim of keeping your numbers straight. Even with the sale of the eight November calls, the position is still net long two contracts: long 15 of the January $20s minus the five January $15 and the eight November $20s. If LeapFrog trades above $20 per share, the profits still will increase as the stock moves higher but the position is now in no danger of losing any money regardless of how high or low the stock goes. Of course, the short November $20 calls can be

rolled through, buying back the November $20 calls and shorting calls with a higher strike in a later month, or rolling both up and out.

Another possibility, though less attractive in my mind, would be to sell 10 of the January $25 calls for $1.50 per contract, or a total premium of $1,500. This would bring the maximum loss down to $500 but also limit the maximum gain to $3,700 if LeapFrog trades above $25 per share. That's not bad, but it pretty much ties you up until the January expiration and takes away the opportunities and flexibility offered by the leverage of having a positive gamma.

The dynamic nature of options trading means there are literally thousands of permutations, including shorting the underlying stock described above, which you can make to adjust the position to align with a particular outlook at a given point in time and price.

Regarding when you should cover the original short call options, I see no reason to buy them back unless the stock takes a bad fall early in the options life and sends its value toward the 50-cent level. At that point, it might make sense to pay the small premium to cover it, hold onto the long calls outright and hope for a rally.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from 1989 to 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to

steve.smith@thestreet.com.