In today's video, we’re going to cover a huge topic, and that’s short strangle adjustments. What short strangles is very high probability neutral trades with options far out of the money, so it’s first important that you have a set of rules in place to avoid over-adjusting.
We have some guides inside of optionalpha.com that you can download as members that give you an idea of when to adjust and how far to adjust things like that, but we’re going to go over an example, a classic example today as we get through these slides.
That said, if the stock moves towards one end of the strategy quickly, you’ll want first to adjust the side of the strategy that the stock is moving away from by moving that option closer. Again, on our chart here, this is what we’re going to do.
Once we see that we have this strategy here and we’re neutral, if the stock is in between our strikes as we enter this trade or fairly neutral and the stock starts sliding one direction or another, what we’re first going to do to make an adjustment is take one side of the trade.
In this case, we’ll take the put side, and we’re going to roll that side closer to the money. What we’re going to do is we’re going to slide this side over, and it's going to make this profit loss diagram much taller and much wider, and that’s going to help even out our breakeven points.
For simplicity, let’s assume that you sold options on either side of the market at a 15% probability of being on the money level which is about a 15 Delta and we’re going to replicate this trade later on.
But one of the ways that we adjust is that we'll look to adjust one side when the short strike increases to a 30 Delta. We’ll place the trade when we have about a 15 Delta on each side.
If that Delta then doubles, so our probability of losing doubles to a 30 Delta, we consider that probably a good time to make an adjustment to this strategy.
What we would do in one case if the stock is moving down towards our put side, in this case, if the stock is moving lower towards our put side, then we would adjust down the call side of the trade closer to the stock price and take in an additional credit.
You can see this is what it would look like. We would adjust this side closer to the market, and this new strategy here is in the dotted red line on the graph.
Now you can see it's a much taller payoff diagram, it’s much taller because we took in additional credit and the breakeven points are out just a little bit wider, really reflecting the new value of the stock and trying to rebalance and reposition the strategy.
One key point here is that when we roll down this call side, everyone always asks, “Well, how far do I roll down that call side? How close to the market do I want to get?” We always say that we try to reset the probability on this side of the trade to a 15 Delta.
When you originally entered the trade, it had a 15 Delta. As the stock is dropping, the Delta of that strike price is also dropping. It’s no longer a 15 Delta because the stock is moving away from that strike price.
We try to reset that probability, and that gives us just a good road-marker or a guidepost to use when we’re trying to decide how far down to roll that side. Another key point here is to make sure that you match the number of contracts during this roll as this takes on no additional risk with your broker.
If you have one put option and one call option in your strangle, you want to make sure that when you roll down that one side that you still have one put and one call when everything is done and over with.
If you have two, then you want to make sure you still have two on either side when you roll it down. This takes on no additional risk for your broker, but that increase in premium helps offset some of the potential loss on the trade and helps widen out your breakeven points.
Let’s go here to the Thinkorswim platform and take a look at an example right now. This is just a simulated trade that I put on today in SPY.
You can see SPY right now is trading about 205.48, and I decided just for the sake of starting this that we’re going to sell the 214 call and the 187 put on either side of the market. Each of those sides is about a 15% probability of success.
You can see the market is moving a little bit as we’re doing this video, but you can see this 214 call is right at about a 15%, about 2% higher, and on the bottom side, the 187 is right at a 15% probability of being in the money, so a probability of losing.
That’s how we’re going to place this trade. You can see the risk profile here, it’s slightly skewed to the downside, and that’s just because the probability of the stock dropping faster is a little bit higher, but this is a balanced trade because of the probabilities being even on either side.
In this case, you can see our breakeven points are right about here and right about here and with the stock right here, it’s just a little bit skewed to the downside, but there is more risk that the stock falls faster than it rises.
In this case, we take in about a 210 credit. We’ll just keep the numbers pretty simple here. We take in about a 210 credit on this trade which helps widen our breakeven points out $2.10 on either end of the strike prices that we select.
Let's assume here that the stock continues to fall. It starts falling, and it starts falling fast, really hard. It’s starting to move away from our call side, and it’s starting to challenge the put side of this trade.
What we said is that if that Delta of the option goes from about a 15 to a 30, (you can see here that right now, it’s about a 15% probability of being in the money) that means that this probability here would have to go to about a 30% chance of being in the money for us to make an adjustment.
The stock has got to move down that far, that fast for us to be able to make an adjustment on this trade. You can see with the other probabilities here that a 30% probability right now is about 197.
Basically, after about a $10 drop is when we’d be looking to make an adjustment to this trade because right now, the 197s have about a 30% chance of being in the money or losing, and if our trade were to be a 30% chance, that might be another $10 drop from here. You can help yourself guesstimate and estimate how far the stock might have to drop for that to happen.
Let's say that the stock does drop $10 from where it’s at right now which is 205. We’re just going to move this over here, and we’re just going to drop this $10 all the way down to 195. Let’s say the stock moves down to about 195 which is about here.
Now, the stock is challenging the put side of our trade. Now, this side of the trade is starting to win money. What we want to do is we want to roll this side closer to the market. We’re going to roll this side closer, try to rebalance the position over where the market is trading right now.
This is going to do two things. It’s going to bank a profit on this side of the trade because it's moving away and it’s going to help move out our breakeven point by the amount of the credit that we take in on this roll.
If we roll this side down closer, we’re looking to make a more narrow (and I’ll just draw it out here in dotted line) strangle that is a little bit higher in premium which helps move out our breakeven points. Again, we’re trying to roll this call side down to the market.
We’re not touching this put side. We’d never touch the side that the market is moving against. That side is already losing. We don’t want to roll that side down because that means we just get ourselves into a situation where we can start compounding losses.
Logistically, what that would look like if you did decide to roll this side down is you would enter that trade as a vertical credit spread. If we already had a position at 214, we could enter a position let's say at 210.
We wanted to roll it down to 210, and we would make a sell order, and we would sell the 210s and we would buyback our 214s that we are short. You can see here that 214, we’re going to buy those back with a vertical spread order.
That one contract that we buyback is going to cancel out those 214s that we were originally short. In this case, you might not take in $133 because that’s live pricing, but let’s say you take in about $80 on the roll down.
The difference between selling the new 210s and buying the new 214s gives you about an $80 credit additional to the 210 credit that you received originally. Now you’ve got a total credit of $290, and that's what helps widen out the breakeven points on this trade.
Now that we’ve made this trade and this adjustment, you can see what this new profit loss diagram would look like here. You can see that now we have the 210s, so our option strategy starts to move this way and it’s a little bit more balanced over the market.
You can see that our breakeven point did, in fact, move out just a little bit further. It’s helping this breakeven point move out further which is why we just continued to roll down the call side.
As the stock continues to move lower, you'll just keep moving down that call side as much as you want or as little as you want. We can keep moving it into 208, and you can see we can just take in more and more credit.
We can move it down to 205, take in a really big credit, maybe $200. But you can see the closer that you move this stock, the more credit you’re going to take in, and the further out you’re going to move those breakeven points.
You can get carried away with making these adjustments. We suggest that you adjust that call side down to a level which is at about the same probability level that you started with.
Whatever the new 15% out of the money level is or 15 Delta is, that's where you want to adjust. You don’t want to adjust too far down from there or else you’d get caught if the stock does make a reversal and turns around the other way.
Alright, wrapping up here with short strangles, the new more narrowed and taller strangle as we have shown you help widen your breakeven points on the trade and more importantly, helps re-center the trade over the new stock price.
That's our goal of making this adjustment. We want to recognize that the stock has made a move lower, try to make an adjustment that takes into account that new stock price and try to re-center the trade over the market.
This will work in the complete opposite. If the stock moves against you towards the topside of your trade, so if it starts moving towards the call side, you’ll want to roll up that put side to about a 15 Delta and re-center the strategy that direction, not touching the call side, but rolling up that put side.
Hopefully this has been a helpful video. This is a huge question that we get, but this is exactly how you do it. There’s nothing more complicated than this. It’s a very simple strategy to do.
You just have to be diligent about setting those rules in place about when you’re going to adjust and how for you’re going to adjust ahead of time before you make a strangle trade.
As always, I hope you guys enjoy these videos. If you have any comments or questions, please add them right below. Until next time, happy trading!