In today's video tutorial, I want to talk about how to adjust a put credit spread that you maybe in or as some other people call it, a bullish put credit spread because you're originally directionally bullish on the underlying stock.
After selling a put credit spread below the market, let’s say that the underlying stock starts to selloff towards your position.
This is the ultimate fear of most traders, is that you enter this strategy, it's a high probability of success and then the stock starts to selloff which is really testing your position because you don't make money as the stock falls.
The question becomes, “How should we hedge or adjust this trade going forward?” For simplicity in our example today, let’s just assume that you sold a $1 wide spread for about $.15 or $15 at the 15% probability of being in the money level.
This also is about a 15 Delta if your broker platform doesn't calculate probabilities. What we would do after making this trade, we would first be triggered to make an adjustment when the short strike of our strategy reaches a 30 Delta.
We’re trading it originally at a 15 Delta, so we’re basically saying that if the probability of losing on this trade doubles up to a 30 Delta, then what we’re going to do is we’re going to adjust this position and make some sort of adjustment that reduces risk.
Here's exactly what we would do. We would take that original put credit spread and we would sell a corresponding call credit spread on the other side of the market for additional credit.
This is a little bit different than what some other companies and guys out there teach. Some other people teach that you want to roll down this put credit spread side, but we don't favor that.
The reason that we don’t favor that is because if you close out this position and rolled down, you’re first closing out a losing trade and banking a loss 100%. Then you're rolling the trade further down, but who's to say that the market can’t keep falling towards your position.
What you end up doing is just creating a situation where you could keep rolling down that put side and creating a compounding loss environment.
What we always say is you add the corresponding call credit side, make sure that you match up both the width of the strikes (in this case, if you're doing a $1 wide strike, you want to do a $1 wide call credit spread) and the number of contracts that you’re trading for no additional risk and that’s really, really important.
Let’s actually go to our broker platform here on Thinkorswim and let’s actually do one of these trades. Let’s say for example that you started off doing this trade with a put credit spread below the market.
What we’re doing here, this is DIA which is the Dow Jones Industrial ETF and it currently closed today at about 176.40. If we were to add a put credit spread below the market for March, it’s got about 56 days to go, we could do it at the 15 Delta or 15% probability of being in the money level which right now is about 161.
What we’re going to do is we’re going to sell the 161/160 credit put spread and we’re going to take in about $.15 in credit. When the market opens, this pricing is a little bit more towards the $.15.
Because the market’s closed, it doesn't quite add up right now, but believe me, it is about $.15 when the market’s open. We’re going to take in about $.15 on this trade. It’s a very high probability of success trade where we’ve got about a 15% chance of losing on this trade.
That means we've got about an 80% chance of winning on this trade and this is reflected in the profit and loss diagram. You can see the stock is currently trading right about here and with our profit and loss diagram, you can see that our breakeven point is all the way out here towards 160.
As the stock starts to fall, we only lose money if it goes beyond that point. It’s a very high probability of success trade, only about an 85% chance of winning, about a 15% chance that it does breach that level and head lower.
But who's to say that it starts moving that direction and you want to make an adjustment. Our trigger point is going to be the Delta of this option which is currently about -13, but if we start to see that probability and Delta get up closer to around 30, that means that our probability of losing has doubled and we’re going to want to make an adjustment.
What we always do when we add the other side to this trade is we want to add the other side at the original probability that we had set below the market. In this case, we'll look to add the other side at about a 15% probability of being in the money or about a 15 Delta as well.
We’re trying to match this up and try to take as even risk as we can on either side of the market. We don't want to adjust this too close to the market. We want to be a little bit slower with our adjustments going forward.
In this case, what we would do is we would sell the 183/184 credit call spread above the market. You can see that takes in an additional $.12 in premium.
We want to make sure that the width of our strikes is exactly the same which is $1 and it is, and we want to make sure that we’re doing the same number of contracts on both sides which is just a one lot spread.
If we do this, you can see that this creates a new iron condor position. Basically, what we’re doing is taking a little bit of our profit potential up here above the market and we’re cutting that off because the market is starting to challenge the bottom side of our trade.
But as we did that and increased our credit that we received, we reduced our max loss on this trade. We can no longer lose more money than our original position. In fact, there’s no way we can lose more money than our original position and it’s all because we took in an additional credit on this trade.
That's exactly why we would continue to roll down this call side closer and closer and closer as the stock continues to fall. Remember, with these put credit spread adjustments, you want to create a new iron condor position and this helps both reduce overall loss and widen your breakeven points on the trade and more importantly.
When you match up the number of contracts and the width of the strikes, you take no additional risk to make this adjustment which means that you're only reducing risk when the market is not moving favorably towards your position.
As always, I hope you guys really enjoy these videos. If you have any comments or questions, please ask them right below in the lesson page. Until next time, happy trading!