Today, we’re going to go over how you would make an adjustment to a call credit spread. After selling a call credit spread above the market, let’s assume that the underlying stock starts to rally higher towards your position.
This is where you inevitably end up starting to lose paper money in your trade as the stock rallies higher towards your strikes. The question is how should we adjust or hedge this trade.
For simplicity, let’s just assume that you sold a $1 wide spread for about $.20 which gives you about a $20 credit at a 15% probability of being on the money level, so about a 15 Delta if your broker platform doesn't calculate those probabilities.
What this means is that your initial trade had about an 85% chance of success, about a 15% chance of losing. It’s a high probability trade, but now the stock is starting to move against you.
What we'll do is we will look to adjust when the short strike reaches a 30 Delta. Remember, we entered this trade, to begin with at a 15 Delta and basically, our personal adjustment for this is if that Delta doubles.
If the risk of us losing money doubles or increases twice, then we'll look to make an adjustment to a credit call spread. Here's exactly what we'll do. We will take that credit call spread, and we will sell a corresponding put credit spread on the other side of the market for additional credit.
This is a little bit different than what most traders try to teach you in that you roll up that call side. We don’t suggest you do that because you roll up that call side, you’re banking a loss and closing out that initial position, plus you’re reestablishing the trade at a higher price and who's to say that the market can’t keep moving higher against that position.
You end up with compounding losses if you adjust that way. What we like to do is add the other side of the trade. You add the put credit spread to the other side, making sure that you match up both the width of the strikes (if your original spread was $1 wide, you want to do a $1 wide put spread) and the number of contracts that you traded, so that you have no additional risk in this trade.
In fact, that is the absolute truth. By making this adjustment, you have no additional risk in this trade, and you’re reducing risk or reducing your max overall loss by doing this.
Let’s look at an example here on our broker platform. We’re looking here at SPY. It’s currently closed today at just about 205. Let’s say that our initial trade was the March options.
We’ve sold the 214/215 credit call spread above the market, and you can see we took in about a $.20 credit to do that and that probability of us losing or probability of being in the money is about 15% or about a 15 Delta. That means this is initially about an 85% chance of success trade, a very high probability trade.
We go to our risk profile here, and you can see with the market trading right here about 205, this is that dotted line right down the middle of the graph, you can see that our strike prices are all the way out here which means that we don't lose money until about 214.80 or so.
That’s exactly where of 214.20 is where we start to lose money. That’s our breakeven point. After that, we ended up losing a couple of hundred dollars because in this case, we’re doing three different spreads.
We take in a credit of about $60. Right now without any adjustments, we have a loss potentially if it moves all the way against us of about $240. What’s going to happen is that we’re going to monitor…
There’s ways that you can monitor and create alerts for this individual strike price. We have other tutorials inside of our membership area at optionalpha.com that helps you understand how to create alerts and monitor these positions without watching them in real-time.
But we’re going to watch and wait and see if this Delta of this short strike, this 214 increases to about 30. When it gets up to a 30 Delta or a.3, it‘s going to double, and that means that our probability of losing doubles as well.
What we're going to look to do is then go down below the market and sell a corresponding put spread at the original probability that we had on the call side, so in that case, about a 15% probability of being in the money or about a 15 Delta.
In this case, right now, we’ll just assume that that spread is the 187/186 and we’ll just go ahead and sell that vertical credit spread as well. In this case, you take in another $8 on this trade.
You probably take in a little bit higher than that, but we’ll just use this for the sake of this argument. But you take in whatever credit that is on that side of the trade and that credit will then create an iron condor that helps reduce the risk of your position.
Now you can see as the market starts to move higher, we’ve now created an iron condor, we’re increasing our risk on the back end of the trade to help offset some risk on the top end of our trade.
What this has done is this has moved up our max loss on this side of the trade to only about $216. It’s reduced our loss a little bit. The more credit that you take in on this roll, the less and less that loss is going to become.
But you’re not taking any more risk to do this. By doing this, you’re reducing your loss 100%. You take in more credit which moves out your breakeven points even further.
The closer that you do roll this strike up… Let’s just say you roll it up to 191/190 and we go close to the market. You can see that the closer we roll this side, we take in, even more, credit and that helps just reduce our loss; it moves up our loss on both sides of the market.
Of course, there’s always a risk that you reduce too far too fast, so you’ll have to play around with that and see what timeframe works best for you, always taking to account how much implied volatility there is and how much time is left in the options expiration.
We obviously don’t like to make these adjustments the day before expiration. We like to be a little bit proactive in how we adjust trades. But that’s the whole thought process and methodology of adjusting that credit call spread.
This creates that new iron condor position helps reduce loss, overall loss and widens your breakeven points on the trade by taking in that additional credit.
Remember, if you do this and you match up the number of contracts that you’re trading on each side and the width of the spreads, you take no additional risk to do this trade which is why it’s such a great adjustment.
As always, I hope you guys enjoy these videos. If you have any comments or questions, please add them right below on the lesson page. Until next time, happy trading!