How many times have you entered an options trade only to have it immediately go against you? You want to make a trade adjustment but you aren't sure how. In fact, you aren't sure whether you should make the adjustment because, what if things reverse and everything would have worked out anyway?
Trade adjustments can be tricky. We don't want to rush into a decision in our current state of panic. In fact, it's actually better to have an adjustment plan ahead of time. The whole topic is complex enough that I decided to add a page to focus specifically on this.
There are actually several things to consider, among them are whether to adjust, when to adjust and how to adjust. I want to spend some time exploring each of these in a fair amount of detail.
The most important decision of all is wither to take any action. Keep in mind that any trade adjustment will help remove risk from the trade in one particular direction but will often add risk in another - or it will limit existing gains as the cost of adding insurance. As a result, the decision to adjust should be based on whether the resulting position accurately reflects an updated market outlook.
For example, in a recent iron condor trade, I talked about the decision to adjust the put side of the position. In that situation, the consideration to buy back a contract of the short put should reflect the fact that I expect the market to move far enough to the down side to make such an adjustment profitable.
It's easy to be temped to take action purely in reaction to a trade gone wrong. When emotions run high (either toward fear or greed), it's probably the wrong time to be making a trade adjustment. If you've planned out an adjustment or two and have a pretty good idea when and how you would apply them it might make sense to adjust.
Remember though that if you've set your position size correctly, you should be able to sustain the loss from this trade without serious impact to your portfolio. The real issue may more about what's going on inside your head in regard to this trade (often referred to as trade psychology).
Next, let's consider when to adjust. In many cases, time is of the essence in making a decision. A decision can sometimes be made too early before all of the signals have been received. For example, consider the following failed hammer pattern on the SPY.
If I had taken some sort of action on that hammer without waiting for conformation I would have been wrong (in that case) and made an existing position worse. That's a case of acting too soon. Consider the day after when the hammer failed to confirm. If I were going to act on a potential change in trend, that day would be the best time to adjust. This was clearly a point when the trend changed and the move was significant.
Likewise, we can't wait too long to make a decision either. If I had waited to adjust a bullish position for a few days, it may have been to late. Most of the bearish move would have been exhausted. As a result, the adjustment would probably have been much less effective.
There are many ways in which to make a trade adjustment. The key is what kind of trade you are starting with. There are really two categories of adjustments. Ones that modify an individual trade and ones that adjust an overall portfolio bias. Examples of the latter could include adding a position consistent with your new bias (i.e. delta adjustment), adding a long or short futures contract or currency pair. Obviously, most of these are outside the scope of this site for now. Perhaps in the future this site will feature content on futures and currencies.
Determining how to adjust a particular position requires a degree of comfort with a number of strategies. Often an adjustment from one strategy to another alters the overall trade construction. For example, consider a 3 contract short put spread that might have been in place prior to the change in market direction following the failed hammer.
If I were to buy back one contract of the short put, that would leave me with a back spread, which has more long puts than short puts. In effect, I now have a long put and a 2 contract short put spread. This gives me additional negative delta but also adds negative theta. It will benefit if the market moves downward but in a strong and fast movement that can offset the negative theta component.
I want to outline some various trade adjustment strategies, discussing pros and cons. These are by no means the entire list of potential adjustments. These are simply the ones I often employ. Others can be used as well but be sure to understand both the advantages and disadvantages (risk).
|Close the position||Simply close the
trade for whatever credit or debit you can.
Advantage - You are out of the trade, you don't have to think about the trade any more
Disadvantage - The trade is done. No chance to benefit if trade reverses.
|Close part of the position||You simply reduce
your position size and therefore your risk in the trade.
Advantage - You are still partly in the trade but with a reduced exposure
Disadvantage - By limiting exposure, you also reduce potential profit
|Buy a long call/put||You are adding
positive or negative delta to the position and to some extent, the
Advantage - Benefits from large moves in the direction of the call or put.
Disadvantage - You're on a timer. This is a negative theta position that will lose money if nothing happens
|Buy back short contracts on vertical spreads||By purchasing some
of the short contracts of a vertical spread, you create a back spread
that has some of the characteristics of buying a long call or put.
Advantage - Can help offset the loss of a position being overrun
Disadvantage - Requires a fairly large move to make up for the cost of buying back short contracts
|Buy a calendar spread||This often helps
vertical spreads and iron condors and is useful when the expected move
is more minor.
Advantage - Creates a potential profit area when a vertical is being overrun
Disadvantage - Won't work if there is a move too far in either direction
|Take trade on opposite side||This would involve
for example selling a short call vertical spread if the put vertical
spread was being overrun. This acknowledges the shift in market bias and
makes sense as a trade on its own.
Advantage - Profit from change in direction offsets loss of trade gone wrong
Disadvantage - Often creates a tight window of profit and means you now have risk in two directions
It's often not enough to simply understand the adjustment strategies. Each existing trade strategy may benefit from certain adjustment strategies more than others. Below is a list of some of my commonly traded strategies with some adjustment ideas and the overall effect of making that adjustment.
|Short put spread||
Remember, that making a trade adjustment is something you want to consider carefully. However, you don't want to wait until you're in the middle of a trade crisis to be making determinations. Usually, I'll consider potential adjustments (if any) when I start seeing signs my trade might be in trouble.
Remember also, that if you've sized your position correctly, there is no absolute requirement to adjust unless you believe there is a strong likelihood of redeeming a position. Adjustments take practice just as trading strategies themselves do. Therefore, before you go out and start throwing on adjustments every time a trade is threatened, paper trade some of these to master timing and the correct selection of your trade adjustment.