In this video tutorial, I want to talk about when to adjust an options trade because I know that after placing a new trade, the next question that’s on most traders minds is, “When should I make an adjustment or hedge?”
If necessary, of course, because if a trade is going great, then you’re obviously going to let the trade go all the way to expiration and have a nice profit. But if a trade is going bad, at what point do you step in and make an adjustment to that trade?
There are two general categories that we have to put these adjustments into, to begin with. I think we always try to categorize everything by risk defined trades which would be trades that are credit spreads, iron condors, calendars in some cases, debit spreads.
Anything where you know exactly how much you can make or lose because with those types of trades, you want to be slower, and this is just a rule of thumb. You want to be slower with your adjustments.
You don’t want to be too quick to make adjustments because you already know how much money you could potentially lose. And if you're placing trades at the right high probability of success level, then ideally, you could just let them go all the way to expiration, and you’d be okay.
When it comes to naked or undefined risk trades, so these would be your strangles and your straddles, any strategy where you're selling options on either end, and you don't have that additional long option as protection.
Then you need to just be a little bit quicker with your adjustments and that’s just a rule of thumb. It’s not saying that you have to make adjustments every single day, but you should just probably watch those positions a little bit closer.
What's been helpful to me personally over the last eight years is just having a set of guidepost or road markers that alert me to make an adjustment or hedge trade.
The reason I set this up in advance is that I want to take my emotion out of the game. We’ll go through a couple of the different ways you can do it here in a second.
But when I setup one of these alerts, as soon as I get a notification of a certain barrier being hit or a certain Delta being hit, then I automatically make an adjustment. There’s no thought in here as far as, “Well, maybe the market might come around, or maybe the stock might rally or fall.”
There’s none of that. Take your emotion out of the game. As soon as you get the alert, make the adjustment. Here is a couple of ways that you can do it.
Again, we will use some of these interchangeably here, there’s no one set way to do it, but these are the ways that we've seen a lot of traders do and probably some really good ways to do it. This is all assuming that you're making the very high probability of success trades, to begin with.
The first way that you can do it is you can make an adjustment when the short strike of your spread (whatever spread you have) reaches a 30 Delta. In our case of most of the trades that we enter, we’re entering trades at about a 15 Delta or a 15% probability of losing on either end.
The trade reaching a 30 Delta means that our probability of losing has doubled. And for us, that’s a good trigger point to make an adjustment because we originally had a 15% probability of losing that's now moved up to a 30% probability of losing, so, at that point, we might want to consider making an adjustment.
The second way you can do it is if you’re a little bit more aggressive, you would say, “I’ll make an adjustment at a 40 Delta.” Whatever position you enter originally, you might make that adjustment at a 40 Delta.
This is also the case where if we make a trade that's an 80% chance of being a winner and a 20% chance of being a loser, we might set that new adjustment level to a 40 Delta because that's a doubling of our probability of losing.
The third way that you can do it is if your initial credit on the trade is increased by two times. I often see some people use five times or three times, but we just use maybe two times or three times as just a guidepost or road marker to use.
But if you initially took in a $.30 credit and now the spread is trading for $.60 or is trading for $.90, whatever it is, you use some initial credit multiplier as to when you can make an adjustment.
The fourth way to do it (and this is a easy way if you’re a beginner) is that you’ll make an adjustment if the stock violates your long strike.
If the stock goes all the way through a short strike and goes all the way through your long strike, you’d consider that a pretty big move and you’d want to make an aggressive adjustment at that point.
Let’s go over a couple of those different ways that we can make that adjustment with a recent trade that we just put on in SPY. We just sold a call spread above the market in SPY, and you can see that SPY is trading at 201 right now and we’ve sold the 208/209 call spread above the market.
This trade has a probability of being in the money of about 23%. When we made the trade, it was about 20%, just rallied towards the end of the day, so it’s about 23% probability of being in the money.
Our Delta on the original position was about 20, so my personal point at which I’m going to make an adjustment on this trade is if this Delta which is currently at 25 reaches 40 because that's going to be a doubling of my probability of losing.
I can visually see how far the stock needs to move for that to be about what happened. You can see finding a Delta of about 40 right now is equivalent to stock at 204. If the market goes from 201 up to 204, so about a $2 move based on where it’s at right now, I might see a doubling of my Delta.
That’s just an approximate that you can use, so you can watch the market and say, “If it moves up another $2 today, maybe my Delta will go up to about a 40, and I might want to make an adjustment.”
But if I was a little bit less aggressive, I might want to do something at a 30 Delta and you can see it’d only take less than $1 move here to get the market up to about a 30 Delta on my short strike because we’re just focusing on that short strike which is the 208 call.
In the third example, we can use some multiplier for the credit of the spread. We originally took in $.30 on this $1 widespread, it’s pretty normal to take in, that's a pretty average trade for us.
If we use a two times or three times multiplier, then we might look to make an adjustment if the spread’s value increases to $.90 or $.60. Somewhere in there, we might look to make an adjustment.
The fourth way that you can do it is if the underlying (in this case, SPY) violates your long strike. In this case, SPY would have to go from 201.63 all the way up past 209 which is your long strike here.
Remember, we sold the 208/209 call spread, so in this case, we only make an adjustment if the market gets all the way up to 209.
You can see that’s probably maybe waiting just a little bit too long to make an adjustment, but it’s going to be different for different people, and your trading styles are going to dictate how quickly or how slowly you make adjustments to these positions.
But this is a really good example of how we can do it in all four different cases that we outlined and what that might look like. Remember that the key here is to have something in place as far as rules so that you can systematize your trading.
We've got a ton of resources and guides inside of optionalpha.com that you can sign up for and get for free downloadable PDFs as far as how to make adjustments to each of the different strategies that are out there and we’ve also got a ton of video tutorials on a lot of these topics as well.
If you want more information on how to make adjustments and including when to make adjustments to particular strategies, you can check them out at optionalpha.com. As always, I hope you guys enjoy these videos.
If you have any comments or questions, please add them right below. I’ll get back to all of those so that you guys get the answers you need promptly. Happy trading!