OAP 114: Managing Inverted Option Positions – Once Difficult, Now Easy

Download The "Ultimate" Options Strategy Guide

Short straddles and short iron butterflies are some of our most profitable option strategies, and a consistent staple when trading in our PRO and ELITE membership levels. However, when it comes adjusting these positions and going "inverted" it can cause even the most experienced traders to freeze up. In today's podcast I wanted to walk through the process of managing inverted option positions and help you understand what numbers to track and how the pricing, profits, and risks work so you can confidently go inverted on your next challenged trade.

Key Points from Today's Show:

  • Often times people assume that managing inverted options positions is very difficult. 
  • However, this fear of managing inverted options mostly stems from a lack of knowledge.

A Short Straddle Review:

A short straddle is one of the building blocks to an iron butterfly. 

The short straddle is selling an at the money option on both the put and the call side. 

Example: Iron Butterfly-Straddle Hybrid (neutral and balanced)

Assume a stock or ETF is trading at $20. We sell the $20 call and $20 strike put. Both options are at the money or very close to being at the money. The convert it into an iron butterfly, we buy options further out on each end. In our case, if the stock is trading at $20, we would buy options at $25 on the call side and down on the put side at $15. So we are buying options $5 out on either end, giving us a risk-defined iron butterfly (Iron butterflies and short straddles are effectively the same thing, just slightly different).

We assume that we get into the initial trade for a $2 overall credit. Now if we have a $2 credit, that means that our breakeven point is at $18-$22. That is really the range that we want this stock to go into (take the credit and add and subtract it from the short strike of $20 to get your profit range). If the stock ended at $20 at expiration, we generate the full $2 credit, everything would expire worthless and we'd collect our entire premium. 

Risk:

Now that we know our widest width is $5, we want to consider our risk in the position. The risk on the position is that the stock moves wildly in one direction or another (a huge move down, or huge move up). That is when we could potentially lose money on this trade. If you subtract out the $2 credit, that means we have $3 of total risk in this position on either side. 

Stock Moves Against You: (See Show 108)

When the stock moves against you, roll up or roll down (depending on the direction of the market) on the unchallenged or untested side. Example, if the market rallies up against your position and the stock goes from $20 up to $23, you want to roll up your $20 puts. If the stock goes from $20 to $13, you want to roll down your call options. 

If the stock is up to $23, it is now $1 beyond our breakeven point. Generally, adjustments are best made within the last 2 and half to 3 weeks to expiration. As you get closer to expiration, make an adjustment to start cutting down on your risk or potential loss. With the stock trading at $23, if we made not adjustments, we would lose $1 on our trade. So this is where going inverted may be a necessary option.

Inverted Trade:

This means your short put option now is above your short call option. Most of the time when you trade a regular strangle, you can do a lot of adjusting and still never get inverted. But once they cross and the put option is now at a higher strike than your short call option, you become inverted.

*Why does this inversion matter? Now, you relationship to expiration is now backwards.

Example:

Stock rallied from $20 to $23. We are now going to roll up our $20 strike puts to the $22 strike level. To roll up, we are going to collect a net credit of 50 cents. Collecting a credit is the basis of what we do when making adjustments. When we collect a credit, we reduce risk. Initial credit we took in was $2, so if we do the roll up adjustment, now we add the 50 cents for a total credit of $2.50.

Now, we have the short $22 puts and the short $20 calls, which means we are inverted by $2. At expiration you are now guaranteed to lose $2 on the spread. However, this is before you factor in any credits that you've already taken in. Considering our $2.50 credit that we have already collected, even if we went through expiration losing $2, we would still have 50 cents of credit left over.

*This is why keeping track of your credits is key whenever you go inverted.

*Whenever possible, maintain an overall net credit that is higher than the width of the inverted strikes. 

*When you invert your strikes, the closer you can get to the stock price, the higher probability of success you will have on the trade.

Example Continued:

In this case, if the stock continues to move higher and traded at our long strike of $25. If the stock traded at $25, we would then again roll up our short puts, going deeper inverted. We could roll up our $22 puts up to $24, collecting another 60 cents in credit. The width of the inverted strikes is now $4, which means that before any credits are factored in, at expiration that particular part of the position will be losing $4. Now, take the $4 and subtract the credits, which was $3.10. This means that the position will lose 90 cents. 

Although this makes it a losing trade, it significantly cuts the risk and overall loss on the trade. When you make adjustments and manage inverted trades, you are essentially trying to reduce the risk in the trade. Instead of focusing on how much money you can make, focus on how much less money you could lose if the stock continues to rally against you. 

Now, when you subtract total credit of $3.10 from our width of $5, you get a loss of $1.90. So if the stock truly did go all the way to $25, then what we would have is a loss of only $1.90 versus $3 per contract. That is a 36% reduction in your loss by simply going inverted.

Closing Inverted Trades at Expiration

  • Closing at expiration requires that `you buy back in the inverted strikes.
  • Close the position for as close to the width of the inverted strike as possible. 
  • Inverted strikes can never trade for less than the inverted strike width. 

Example: if you have a $2 inversion, then buying back those two options together will never cost less than $2 because that's how much money someone can make if both options when to expiration. If you are $3 inverted, buying back those inversions will never cost less than $3, etc.

Try to buy back those options when it gets closer to expiration for as close to the width of the strikes as possible. In our case, if we were inverted by $4, we would try to place an order for $4.01 and buy back the inverted options for $4 or $4.01 or $4.02, etc. 

Take-Aways:

  • Managing inverted positions is really nothing more than tracking everything with pen and paper. 
  • Track your initial credit and credits gained from going inverted so that you know where you stand in your position.
  • Use the inversion to minimize risk and reducing the overall loss on the trade.
  • Buy back inversions for a price close to the width of the strike as possible. 

Option Alpha Podcast Show Notes[FREE Download] Podcast Show Notes & Transcript PDF: No time to read the show notes right now? We've made it incredibly easy for you to save time by giving you instant access to the complete digital version of today's show. Click Here to Download Your FREE Copy

Free Options Trading Courses:

  • Options Basics [20 Videos]: Whether you're a completely new trader or an experienced trader, you'll still need to master the basics. The goal of this section is to help lay the groundwork for your education with some simple, yet important lessons surrounding options.
  • Finding & Placing Trades [26 Videos]: Successful options trading is 100% dependent on your ability to find and enter trades that give you an "edge" in the market. This module helps teach you how to scan properly for and select the best strategies to execute smarter option trades each day.
  • Pricing & Volatility [12 Videos]: This module includes lessons on mastering implied volatility and premium pricing for specific strategies. We'll also look at IV relativeness and percentiles which help you determine the best strategy to use for each and every possible market setup.
  • Neutral Options Strategies [7 Videos]: The beauty of options is that you can trade the market within a neutral range either up or down. You'll learn to love sideways and range bound markets because of the opportunity to build non-directional strategies that profit if the stock goes up, down or nowhere at all.
  • Bullish Options Strategies [12 Videos]: Naturally everyone wants to make money when the market is heading higher. In this module, we'll show you how to create specific strategies that profit from up trending markets including low IV strategies like calendars, diagonals, covered calls and direction debit spreads.
  • Options Expiration & Assignment [11 Videos]: Our goal is to make sure you understand the logistics of how each process works and the parties involved. If you don’t feel confident in the expiration processes or have questions that you just can't seem to get answered, then this section will help you.
  • Portfolio Management [16 Videos]: When I say "portfolio management" some people automatically assume you need a Masters from MIT to understand the concept and strategies - that is NOT the case. And in this module, you'll see why managing your risk trading options is actually quite simple.
  • Trade Adjustments/Hedges [15 Videos]: In this popular module, we'll give you concrete examples of how you can hedge different options strategies to both reduce potential losses and give yourself an opportunity to profit if things turn around. Plus, we'll help you create an alert system to save time and make it more automatic.
  • Professional Trading [14 Videos]: Honestly, this module isn't just for professional traders; it's for anyone who wants to have eventually options replace some (or all) of their monthly income. Because the reality is that mindset is everything if you truly want to earn a living trading options.

Option Trader Q&A w/ Travis

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 Travis, who asks:

I have been trading stocks for 15 years, and just recently started trading options. I am interested in buying the Toolbox, but feel that I don't have enough knowledge of the nomenclature to correctly operate the Toolbox. Is there a resource that will teach you how to utilize it so that we would know enough to work the optimizer and other parts of the Toolbox? Thank you!

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.

PDF Guides & Checklists:

  • The Ultimate Options Strategy Guide [90 Pages]: Our most popular PDF workbook with detailed options strategy pages categorized by market direction. Read the whole guide in less than 15 mins and have it forever to reference.
  • Earnings Trading Guide [33 Pages]: The ultimate guide to earnings trades including the top things to look for when playing these one-day volatility events, expected move calculations, best strategies to use, adjustments, etc.
  • Implied Volatility (IV) Percentile Rank [3 Pages]: A cool, simple visual tool to help you understand how we should be trading based on the current IV rank of any particular stock and the best strategies for each blocked section of IV.
  • Guide to Trade Size & Allocation [8 Pages]: Helping you figure out exactly how to calculate new position size as well as how much you should be allocating to your each position based on your overall portfolio balance.
  • When to Exit/Manage Trades [7 Pages]: Broken down by option strategy we'll give you concrete guidelines on the best exit points and prices for each trade type to maximize your win rate and profits long-term.
  • 7-Step Trade Entry Checklist [10 Pages]: Our top 7 things you should be double-checking before you enter your next trading. This quick checklist will help keep you out of harms way by making sure you make smarter entries.

Real-Money, LIVE Trading:

  • EWZ Iron Butterfly (Closing Trade): After nearly pinning the stock at our short strikes, and thanks to the volatility drop, we netted a $600 profit on this iron butterfly trade.
  • VXX Short Call (Closing Trade): One of the most consistent and profitable options trades we can make is shorting pure volatility with VXX and today we closed this naked short call in VXX after a couple days for a $420 profit.
  • DIA Iron Condor (Adjusting Trade): This neutral iron condor in DIA is need of a quick adjustment early this week as the market continues to rally. In this video, we'll discuss why I'm adding an additional put credit spread while also choosing NOT to close out of our current put credit spread due to pricing reasons.
  • COP Short Put (Closing Trade): These single short puts in COP acted as a great hedge for our other bearish bets in oil this month and helped smooth out our returns after we closed them for a nice big profit.
  • TSLA Put Debit Spread (Closing Trade): Although many people thought we were crazy for getting bearish in TSLA this pre-earnings put debit spread trade made us $200 today. After the huge run up from $140 to $260 and getting some technical sell signals, we were pretty sure this stock would pull back.
  • MON Iron Condor (Closing Trade): Following a huge drop in implied volatility we worked hard to close this MON iron condor trade adjusting the order multiple times to fill before the end of the day.
  • IBB Call Debit Spread (Opening Trade): We'll show you how I started searching for a new bullish trade and eventually found a low volatility trade in IBB looking for a move higher to hedge our portfolio.
  • TLT Iron Butterfly (Closing Trade): Following the Brexit vote TLT and bonds traded in a nearly $8 range really quickly - even still the drop in implied volatility helped generate a $330 profit for us.
  • XBI Call Debit Spread (Closing Trade): Got lucky picking the exact bottom for our entry in this call debit spread for the XBI biotech ETF which ultimately was closed for a profit of $165 today on the rally higher.
  • COH Iron Butterfly (Earnings Trade): Shortly after the market open we close out of our COH earnings trade for about a $160 profit, leaving just 1 leg on to expire worthless.
  • EWW Debit Spread (Closing Trade): Using some of the technical analysis signals we discovered in our backtesting research, we were able to make a quick $130 profit on this bearish EWW debit spread trade.
  • IBM Iron Condor (Earnings Trade): Shortly after the market opened you'll follow along with me as we watch volatility drop and liquidity come into the market before closing out the position for $250 profit.
  • SLV Short Straddle (Opening Trade): Using our watch list software we decided to continue to add to our existing SLV short straddle position with a new set of strike prices reflective of the move lower in the ETF recently.

Thank You for Listening!

I'm humbled that you took the time out of your day to listen to our show, and I never take that for granted. If you have any tips, suggestions or comments about this episode or topics you'd like to hear me cover, just add your thoughts below in the comment section.

Want automatic updates when new shows go live? Subscribe to the Option Alpha Podcast on iTunes, Google PlaySoundCloud, iHeart Radio or Stitcher right now before you forget - it's fast and easy.

Did You Enjoy the Show?

Please kindly consider taking just 60-seconds to leave an honest Review on iTunes for The Option Alpha Podcast. Ratings and reviews are extremely helpful and greatly appreciated. They do matter in the rankings of the show, and I read each and every one of them!

Also, if you think someone else in your social circle could benefit from the topic covered today, please share the show using the social media buttons you see. This helps spread the word about what we are trying to accomplish here at Option Alpha, and personal referrals like this always have the greatest impact.

About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and two daughters.