In this video, we're going to talk about knowing when to adjust an options trade or not. So adjustment timing is a very popular question we get from our members, in fact, if I could guess we would probably get around two to five different questions, or support tickets, or forum threads around this concept of making adjustments and timing almost every single day.
So it is an extremely popular concept, hopefully, something we can help address with a little more clarity here in this video.
Now first, it's important to understand that there are two extremes to adjusting a trade and I think the first extreme that I'll go through is using the example of medicine because medicine is a great analogy for how you should be managing your portfolio and adjusting.
And I love to use analogies as you probably have already, already are aware. So my father's diabetic, actually most of the men on my side of the family have diabetes, and he had been through a bunch of medicine to his doctor and got to the point where he was taking so much medicine that they were conflicting with one another.
He was taking five things in the morning and two things in the afternoon and whatever the case is and they all individually were trying to accomplish their little mission. But then collectively they ended up becoming a big mess and ended up sending him into a bad physical state and a bad health state.
So the analogy here is that if you're trading, there is an extreme where too much trading, so too much adjusting, can be detrimental.
And yes, you could be trying to do individually good things to each position, so you're adjusting this position, and it makes sense, and this one and it makes sense, but collectively all of the adjustments end up being this overdose or this overload of adjustments.
You have to realize there is a point in which you can over-adjust somethings or over-trade them. Now, on the other hand, you could also run into the other side of it, which is analysis paralysis or overthinking.
I love this image and this quote from a higher perspective that says, Overthinking: the art of creating problems that weren't even there. And this is a lot of traders I see actually, most traders I see kind of over-analyze every possible scenario and situation for making an adjustment.
They get into this analysis paralysis where they end up not doing anything at all, which could be detrimental to maybe doing something and maybe it didn't work out exactly like you thought or planned or strategized. But at least it was doing something better than nothing.
So again, there are these two concepts, and obviously, you have to find the balance between too much and not enough adjusting that's right for you and your risk tolerance. I can't tell you what that ends up being at.
It's so many different factors that go into it as far as the trades that you're making, your position size, etcetera, etcetera. I can tell you, in my opinion, I'm always slower to adjust, so I always air on the side of maybe adjusting a trade but not over adjusting the trade.
Making small adjustments in small increments along the way and always try to make adjustments on a slower basis, because I know that long term, the edge in option selling is still in my favor.
So even if I didn't make any adjustments I'd still win a certain amount of time, I'd still hit my targeted portfolio probability of success and return. I can still hit all of that long term, so that's why I'm just a little bit slower in pace in how I adjust trades.
Again that's just my personal preference. So again the question is, when do you adjust or hedge a trade and how can we make it as systematic as possible to remove our emotions? Well, the answer is you have to use trigger points and alerts.
And I think you have to use both of these in conjunction with one another to makes this effective for your trading. Trigger points for me have been incredibly helpful because it's a set of road markers or guideposts, whatever you want to call them, that tell me when it's time to make an adjustment or hedge a trade.
And basically what I do is I set up these automated alerts in advance that help take my emotions out of the game, and now it becomes, gets an alert, make an adjustment. So the if, then statement.
If I get an alert, meaning I'm not going to watch and monitor and babysit the trade the entire time. If I get an alert, or I get a notification that something's happened that triggers me then to make an adjustment, I'll make that adjustment immediately.
And so that's the ways that I've set it up with my portfolio. And again I'll go through some examples here, in detail, as we work through this video. So there are some popular trigger points, and I want to first talk about them, and then we'll go through them here with an example from a live trade that we currently have going on right now.
The first trigger point that you can set up is your short strike reaches a thirty delta. I have to tell you that the initial assumption here is that you're entering all of your trades at about a seventy percent chance of success.
Okay, so we'll go through a couple of examples here, but we're assuming that all of your trades are entered at about a seventy percent chance of success and in this case if you did a strangle, each side of your trade has about a fifteen percent chance of being in the money.
So if you sold the call option and you sold a put option, they each individually have about a fifteen percent chance of being in the money, or they're at about a fifteen delta when you initially enter the position.
The first trigger point then is if your short strike on one side or another reaches a thirty delta. And what that means is that on one side of your trade the probability of losing went from fifteen percent up to thirty percent.
So basically a doubling in your probability of losing on that side of the trade. You could also use a short strike going to forty, so if you're maybe a little bit more, or you want the trade to work a little bit more, you can withstand a little bit more pressure.
Meaning that you can withstand the trade going against you a little bit sooner and maybe for a little bit longer you can enter a trigger at a forty Delta short strike. Instead of the delta going from fifteen to thirty, you're going to let it go, even more, all the way up to forty.
The stock has to move against you in a bigger way for you to be triggered to make an adjustment. The third way that you can do it is you can do a two X of your initial credit, or, I mean, you can put anything X here. You can do a three X of your initial credit, four X, whatever the case is.
But let's say that you entered a strangle and you took in, let's say a hundred dollars. If the value of that strangle goes up two X to three hundred dollars and now you're looking at a two hundred dollar loser.
That might then trigger you to make an adjustment. So now the trigger is now based on the value of the contract that you traded or the strategy that you traded versus the short strike probabilities and deltas.
Not something we typically do here as far as adjustment techniques, we don't typically use this value two X credit but I know it's very popular out there and obviously, I wanted to cover it. So the last one that you can try to use is when the long or when the stock breaches your long strike.
So this would be an adjustment technique where you're going to wait for the stock to go completely against you, maybe you sold a call spread or sold a put spread down below the market, and you're going to wait for the stock to breach the long strike of that strategy.
Not the short strike that we can maybe look at in trigger number one or trigger number two. But you're going to wait for the stock to go completely in the money on either end beyond your long strike before you make an adjustment.
And again, it's not to say that any of these are necessarily better than one or the other it's just you have to understand how long you're waiting, maybe how much risk you're willing to take or not or whatever the case is.
Let's go through number one here and talk about what a short strike thirty deltas might look like and again we're going to use a really good example by building out a new trade here in Linkedin. And again we're on our broker platform in Thinkorswim.
This is all live, real-time market data at the time we're doing this video, but we're going to build out a trade here in Linkedin, assuming that you entered a neutral iron condor where you can do it as a straddle.
Whatever you want to do and we're going to use these adjustment trigger points and kinda set them up one by one so you can see how each of these might work.
If we're looking at the Macon tracks for Linkedin you can see that to initially set up this iron condor and again be at about a seventy percent chance of success we're going to target each side of the trade or our anchor strike price to be around a fifteen percent probability of being in the money.
Now the eighty-fives in this case for Linkedin about twelve and a half percent, so we're going to go up to the nineties. There's no fifteen percent probability on either side, but the nineties are around a 12 delta, about a seventeen percent chance of being in the money.
We're going to use those on the bottom side and then on the top side we're going to use the one forty strikes cause those are almost right out of fifteen percent chance of being in the money.
So we're going to set our anchor strikes or our short strikes for this strategy at the ninety puts and then the forty calls above the market. In this case, we're going to build out an iron condor in Linkedin, and we're just going to add each of these sides here real quick so we can build out this strategy and kind of talk about it a little bit more.
And then we're going to sell the put spread down below the market. Great. That can get us our advanced order here, which is our iron condor. So now you can see we've taken a creed of about one twenty-five and I'm just rounding up here, roughly a seventy percent chance of success.
Okay, so this might be a trade that you look at, but we're just going to use it as an example here for adjusting. Now if we enter this trade, let's assume we hit confirm and said enter this trade and it's now working in the market.
So we'll throw it over on the Analyze tab and take a look at what the risk profile looks like, and you can see it's a very neutral, even, iron condor. Again, a very simple trade that most people would make with the stock trading right in the middle of our range as neutral as possible.
Now the question becomes how do we set up these initial trigger points to let us know when we need to make an adjustment to this trade because we don't want to babysit this trade. Meaning, I don't want to come in here every single day and have to check Linkedin or any of my other trades and say okay, do I have to make an adjustment, when do I have to make an adjustment.
Then I get emotional, what's the market like? Am I winning the position, am I not? Whatever the case is. Setting up these trigger points is going to be helpful in streamlining your trading process and removing your emotions. So how do we do it?
The first on that we looked at was a thirty delta trigger point. What a thirty delta trigger point means is that if either side increases the short strike, which is the one forty on the call side or the ninety on the bottom side, on the put side.
If either side increases it's Delta from basically wherever it is to a thirty delta then we would make an adjustment. In this case, we think about it logically as a doubling of risk on one side, because if the initial probability of losing on, lets say, the call side or the stock going up to one forty is only about fifteen percent.
If the delta or the probability doubles on that side to thirty percent, then we have a doubling of risk. We have a two times higher likelihood of losing on the call side, meaning that the stock has moved against us.
Remember the only way that the delta increases is if this strike price becomes a lot closer to where the stock is trading. Notice that if the stock is right now at about one fifteen the delta or a strike price with about a thirty Delta right now is about a one thirty strike.
Basically what we're looking at is if the stock moves up about ten dollars we should see this delta move up to about a thirty Delta, okay? So what we're going to do is we're going to right-click here and look at the delta, it's currently nineteen, so it may be a little bit different, again deltas are just a very rough approximate.
But you're going to use that probability that you still used to enter your initial trade. We're going to right click here, and we're going to create an alert.
Once you create an alert this new alert dialog box is going to come up and basically what it's going to say, is it's going to say okay we're going to look at the stock or the spread and it's going to notify us whenever the delta crosses at or above whatever it's at.
Now, initially, it's going to give us a price of where the Delta is right now. In this case what we want to do is we want to change this to thirty. So once we change this to thirty, then we're going to say okay, this new alert will only activate if this delta on this option goes up to thirty.
That's the only time that it'll trigger us and we can get notified via email, or we can get notified via text message, or whatever the case is you can get notified a bunch of different ways. I like to do email because I just want to be notified via email.
I'll get a nice little email that says, hey, the delta for Linkedin is now above thirty. That is my trigger point to come in here an make the adjustment technique, some of the stuff that we're going to talk about further along in track number three here.
But that's how you set up this adjustment or this alert on the top side. Now again, you could set up this delta to be at a forty Delta. So if you want to say, okay, I'll only adjust this trade if the delta goes up to forty.
Okay great. Set up the trade to adjust only at forty, but remember what you're doing here. A forty delta is letting the stock move about fifteen dollars against your position before you make an adjustment.
Remember the option with about a forty Delta right now, or something close to it is the one twenty-five strike. So if the stock were to move up about fifteen dollars, that would create a basically a forty Delta for your short strike.
You just have to understand that you might be, you have to willing to accept maybe a little bit more risk on that trade initially, and maybe adjust it a little bit slower later on in the process, okay?
On the put side, we can do the same technique for adjusting our short strike on the put side. The short strike on the put side is a negative twelve Delta right now because we sold the nineties. Again we can just right click on this, say create an alert and now what we want to do is we want to say Delta at or below.
This is the key point here because you want to make sure that with your negative put deltas that you put it at, at or below negative thirty or negative forty or wherever you want to be.
If it says at or above when you create this alert you'll automatically get an email because it's going to be above whatever price that you entered in there. Just make sure that you double check and you say, okay on the put side I want the Delta at or below negative thirty.
And, again, when the risk in this trade goes up from a 17.73 percent probability to somewhere around a thirty, thirty-two percent probability of losing on that one side, then you'll get an email alert that says, hey look Linkedin has moved far enough that this trade is now at risk on one side of the spread or one side of the iron condor.
Again, with these anchor points and these trigger points, you're doing everything off of the short strikes. The one forty calls, the seventy puts or the ninety puts, you're doing everything off of these anchor strikes. If you're doing an iron condor, this works the same as if you're doing a strangle.
It doesn't matter as long as you're doing a short premium strategy this is the best way to do it. If you're doing a credit spread you can do it the same way; you just have to set it up one side versus with an iron condor you might have to set up two of these alerts on either side of the trade.
If we go back to our popular triggers here, we cover the short strike at a thirty delta, how to set that up, how to set up those triggers. Same thing with a forty Delta.
Again you can use any combination in here we just arbitrarily said you could look at thirty you can look at forty, whatever the case is, use something around these numbers, thirty-five, forty-five, whatever works out best for you.
Set up those triggers to let you know that the value of the options or that the probability of the options going in the money has now increased and now you might need to make an adjustment to this trade.
Number three is the value of the contract has now gone up two X from the initial credit. This one's going to be a little bit different and harder to set up triggers. In fact, most of the ways that you can set up triggers for number three here or the value going up by some X percent is very antiquated and takes a lot of steps.
We're not going to go through in this video. I don't think you need to do it. I think number three is one of those where if you're going to use that as your basis for making an adjustment you just have to watch the value of the contract go up.
In this case, if the contract that you sold in Linkedin were valued at one hundred and twenty-five dollars, a two X of that would be about three hundred and seventy-five dollars.
Again, if the value of the contract goes up from one twenty-five all the way to three hundred and seventy-five, again two times higher than it is right now or two X higher than it is right now, then you would consider making an adjustment.
The reason I don't use this technique to be completely open and clear, the reason I don't use this technique is that the value of these options can go up if implied volatility goes higher.
Meaning, if we didn't properly enter the trade with really high implied volatility or fairly high implied volatility, and volatility rose in Linkedin, the stock doesn't have to move anywhere. Meaning the stock price can stay the same. Volatility going up then creates the value of this option to go up as well.
The reason I don't use this is, one, you can't automate the value of these options and checking these for alerts, it's very hard and antiquated to do. It would create a lot of work to do that. Number two is that it's not directional based, based on the value of the underlying stock.
What I like to look at more so is the directional basis of the underlying stock. Is the stock moving against me or is it not? In this case, you could have a situation where the stock doesn't even move against you at all, and the value of the options go up, you get triggered to make an adjustment, but there's no adjustment really to be made.
There's nothing you can want to do or would need to do in that situation. Number four is a very popular one. This is, again, one that you would want to use if and only if the stock made a large move against your position, you're willing to hold it.
That's if the stock breaches your long strikes. Again, going back here to our platform, if we were looking at our Linkedin trade, our long strikes, in this case, are our forty-five calls and our eighty-five puts.
If you're going to do this with a straddle or a strangle you'd be looking at the stock breaching the short strikes because you wouldn't have any long strikes. That's obviously what you'd be focusing on.
But, if you're going to be doing an iron condor or credit spread or something along those lines you'd be looking at the stock breaching these long strikes. Which, again, the one forty-five call and the eighty-five put down below the market.
You'd set up these alerts very similar to what you did before and we basically just click on the eighty-five strikes here, we'd right click on create an alert, and then now what we want to say is we want to say that the actual stock itself, so instead of the spread but the actual stock itself, is now at or below our eighty-five strike price, okay?
That's how you'd set it up for the actual strike price, or the stock breaching that long strike price. Again, this is setting it up on the bottom side with our put strike. We set up this alert all the way down below the market.
You can see Linkedin is trading all the way above the market at one fourteen right now. It's only going to trigger and notify us via email if the stock price is at or below eighty-five dollars. Again, that would then trigger us to come in and make some adjustment.
If we want to do it on the top side, we could say okay, at or above our call strike on the long side, which is the one forty-five calls above the market.
Now you can see your trigger is now set up all the way at the one forty-five strike above the market and the stock still is about one fourteen, one fifteen or so, trading right now.
Very, very easy to do that but remember that's going to push you to the limit and not give you a lot of time to make an adjustment. It is going to give the stock more room to move, of course, a lot more of a fluctuation in price as it gets closer to expiration.
There's no right or wrong way to do it here I'm just trying to help you understand these different ways that you can set up triggers for how you adjust a trade going forward. Some common sense comments that I want to add.
Generally, if there's a lot of time left in the expiration of the contracts, I'll let the trade run against me a little more. Again, this is not to say that every time that we get an alert, we have to make an adjustment. Because as we talked about previously, making an adjustment has to make sense for the trade and the portfolio.
If there's a lot of time left until expiration, maybe the stock made a quick one day move against me, and now my Delta went from fifteen to thirty in the first day okay, maybe I'll let it run another couple days to see hey, is this trend really going to continue or was this just a one day pop against me?
If I've got a lot of time, I'll let the contracts work a little bit more and be a little bit more flexible in when I adjust it because I want the probabilities to have a lot of opportunities to work themselves out.
This also means, obviously, that if we are limited in time meaning it's nearing expiration, fifteen days or sooner, then we want to be a little bit more proactive in some of our adjustments. We don't necessarily want the stock to run against us a little bit more. We want to be a little bit more proactive in how we trade.
Always try to avoid adjusting too close or too fast. This kind of goes on the same lines of the other one. You can always make more adjustments if needed later on.
I'm a big fan of making small incremental adjustments along the way, meaning I will roll contracts closer by a small amount because I know I can keep rolling them closer and closer and closer all the way to expiration.
What you don't want to do is you don't want to be triggered to make an adjustment and then make the most aggressive adjustment possible, take in as much credit as possible and try to reduce as much risk as possible so early in the expiration cycle that you price yourselves out of the market.
You create a strategy that has no potential for actually winning. For example, if we go back to our Linkedin trade, a common adjustment for an iron condor is to roll one credit spread closer to where the stock is trading. Let's say that Linkedin all of a sudden starts moving up to, let's say one twenty.
Which is a five dollar move but or a hundred dollar stock, not a huge, move that would necessarily trigger us to make a massive adjustment. But if you then rolled up your put spread side all the way to one twenty, and now you're new resulting position in Linkedin looked like this, a tall, thin, iron condor, you've pretty much given yourselves a very small window of opportunity to make money.
Yes you made an adjustment, yes it probably reduced risk, but you've also dramatically limited your ability to make an adjustment. Again, these contracts are forty or fifty plus days away. There's a lot of time for Linkedin to move.
It's going to be hard pressed to pin a stock in a twenty dollar range like Linkedin that might be a big mover. What I favor is just making small adjustments, roll up that put spread side a little closer then you can roll it up closer if the stock continues to move against you.
If it continues to move against you, you keep rolling up that put spread side closer and closer and closer. You make these small incremental adjustments along the way so that you don't over adjust the position too much and be too aggressive in how you do it.
The last thing is, there is no perfect adjustment timing sequence, and you always have to consider the impact on your overall portfolio before adjusting. As we've talked about in numerous videos before, it is more important to consider the impact o an adjustment on your portfolio than the individual position.
If your individual adjustment to, let's say Linkedin that we're looking at right now and that was our case study if this adjustment in Linkedin turns Linkedin from a loser to a winner, great.
But if that same adjustment that turns Linkedin from a loser to a winner also turns the entire portfolio from begin winning right now, even without adjusting Linkedin, to a losing situation and unbalances you then it's not a good adjustment for your overall portfolio.
Consider that, analyze the trade, take a look at it, see what really can work for your portfolio. Again, the key here is to have something in place and stick with it for awhile. My suggestion, pick from one of the four popular trigger points, work with it for a couple of months, then switch if needed.
To give you guys an idea of where I stand on trigger points before we end this video. Where I focus a lot of my adjustment timing and techniques is around the thirty to forty Delta. There's no right or wrong answer in here. Again, I'm a little bit fluid in which one I might pick based on timing.
If a stock moves against me quick initially and it's the first day the I have the trade on, I might be a little hesitant to adjust it so quickly in the cycle. I might give the stock another couple days to move against me if it does before I make an adjustment.
I'm always slower to make adjustments than possibly necessary. I do focus on the short strike deltas; I think that's the better way to go.
I think when you actually look at a trade and think about the logic behind why I focus on the short strike is because I want to know more so than the value of the option, because the value of the option can go up or down any given day based on implied volatility et cetera, but I really want to know is the stock really moving against me or is it really not?
Is my position becoming less and less likely to profit or is it not? For me, I base a lot of that decision on Delta and probability of being in the money for the short strikes.
I want to know, look if the stock's moving against me to the downside, these deltas and this probability are going to go up, they're going to alert me to the fact that I might to make an adjustment. Same thing on the top side.
If the stock moves against me to the top side and starts moving higher, these deltas and this probability of losing are going to go up. That's going to alert me to how long or how short I should get in the stock or make an adjustment, whatever the case is.
The other thing that I like about using deltas and probabilities is that it's time dependent. Remember these probabilities and deltas will adjust as you get closer to expiration.
We're about fifty days out from May expiration right now, if we looked at this exact set up and if Linkedin didn't move in between now and let's say the next ten days, these deltas and these probabilities would adjust to reflect the fact that there's ten days less to go in the expiration cycle.
By using delta you naturally have this hedge or this time factor that's built in so it can help you know when to make an adjustment based on how much time is left. Again, that's another reason why I like to use the delta of each short strike as my trigger point for making adjustments versus the long strike of a particular strategy or the overall credit received.
That's how I focus and how I've been taught and find to be very successful in how we make adjustments here at Option Alpha. Hopefully, that helps out; I hope you enjoyed this video. Hopefully, it brings a lot of clarity to adjustment timing.
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