Short straddles and short iron butterflies are some of our most profitable option strategies, and a consistent staple when trading. However, when it comes to adjusting these positions and going "inverted," it can cause even the most experienced traders to freeze up. In this podcast I wanted to walk through the process of managing inverted option positions and help you understand what numbers to track and how the pricing, profits, and risks work so you can confidently go inverted on your next challenged trade.
Key Points from Today's Show:
- Often times people assume that managing inverted options positions is very difficult.
- However, this fear of managing inverted options mostly stems from a lack of knowledge.
A Short Straddle Review:
A short straddle is one of the building blocks to an iron butterfly.
The short straddle is selling an at the money option on both the put and the call side.
Example: Iron Butterfly-Straddle Hybrid (neutral and balanced)
Assume a stock or ETF is trading at $20. We sell the $20 call and $20 strike put. Both options are at the money or very close to being at the money. The convert it into an iron butterfly, we buy options further out on each end. In our case, if the stock is trading at $20, we would buy options at $25 on the call side and down on the put side at $15. So we are buying options $5 out on either end, giving us a risk-defined iron butterfly (Iron butterflies and short straddles are effectively the same thing, just slightly different).
We assume that we get into the initial trade for a $2 overall credit. Now if we have a $2 credit, that means that our breakeven point is at $18-$22. That is really the range that we want this stock to go into (take the credit and add and subtract it from the short strike of $20 to get your profit range). If the stock ended at $20 at expiration, we generate the full $2 credit, everything would expire worthless and we'd collect our entire premium.
Now that we know our widest width is $5, we want to consider our risk in the position. The risk on the position is that the stock moves wildly in one direction or another (a huge move down, or huge move up). That is when we could potentially lose money on this trade. If you subtract out the $2 credit, that means we have $3 of total risk in this position on either side.
Stock Moves Against You: (See Show 108)
When the stock moves against you, roll up or roll down (depending on the direction of the market) on the unchallenged or untested side. Example, if the market rallies up against your position and the stock goes from $20 up to $23, you want to roll up your $20 puts. If the stock goes from $20 to $13, you want to roll down your call options.
If the stock is up to $23, it is now $1 beyond our breakeven point. Generally, adjustments are best made within the last 2 and half to 3 weeks to expiration. As you get closer to expiration, make an adjustment to start cutting down on your risk or potential loss. With the stock trading at $23, if we made not adjustments, we would lose $1 on our trade. So this is where going inverted may be a necessary option.
This means your short put option now is above your short call option. Most of the time when you trade a regular strangle, you can do a lot of adjusting and still never get inverted. But once they cross and the put option is now at a higher strike than your short call option, you become inverted.
*Why does this inversion matter? Now, you relationship to expiration is now backwards.
Stock rallied from $20 to $23. We are now going to roll up our $20 strike puts to the $22 strike level. To roll up, we are going to collect a net credit of 50 cents. Collecting a credit is the basis of what we do when making adjustments. When we collect a credit, we reduce risk. Initial credit we took in was $2, so if we do the roll up adjustment, now we add the 50 cents for a total credit of $2.50.
Now, we have the short $22 puts and the short $20 calls, which means we are inverted by $2. At expiration you are now guaranteed to lose $2 on the spread. However, this is before you factor in any credits that you've already taken in. Considering our $2.50 credit that we have already collected, even if we went through expiration losing $2, we would still have 50 cents of credit left over.
*This is why keeping track of your credits is key whenever you go inverted.
*Whenever possible, maintain an overall net credit that is higher than the width of the inverted strikes.
*When you invert your strikes, the closer you can get to the stock price, the higher probability of success you will have on the trade.
In this case, if the stock continues to move higher and traded at our long strike of $25. If the stock traded at $25, we would then again roll up our short puts, going deeper inverted. We could roll up our $22 puts up to $24, collecting another 60 cents in credit. The width of the inverted strikes is now $4, which means that before any credits are factored in, at expiration that particular part of the position will be losing $4. Now, take the $4 and subtract the credits, which was $3.10. This means that the position will lose 90 cents.
Although this makes it a losing trade, it significantly cuts the risk and overall loss on the trade. When you make adjustments and manage inverted trades, you are essentially trying to reduce the risk in the trade. Instead of focusing on how much money you can make, focus on how much less money you could lose if the stock continues to rally against you.
Now, when you subtract total credit of $3.10 from our width of $5, you get a loss of $1.90. So if the stock truly did go all the way to $25, then what we would have is a loss of only $1.90 versus $3 per contract. That is a 36% reduction in your loss by simply going inverted.
Closing Inverted Trades at Expiration
- Closing at expiration requires that `you buy back in the inverted strikes.
- Close the position for as close to the width of the inverted strike as possible.
- Inverted strikes can never trade for less than the inverted strike width.
Example: if you have a $2 inversion, then buying back those two options together will never cost less than $2 because that's how much money someone can make if both options when to expiration. If you are $3 inverted, buying back those inversions will never cost less than $3, etc.
Try to buy back those options when it gets closer to expiration for as close to the width of the strikes as possible. In our case, if we were inverted by $4, we would try to place an order for $4.01 and buy back the inverted options for $4 or $4.01 or $4.02, etc.
- Managing inverted positions is really nothing more than tracking everything with pen and paper.
- Track your initial credit and credits gained from going inverted so that you know where you stand in your position.
- Use the inversion to minimize risk and reducing the overall loss on the trade.
- Buy back inversions for a price close to the width of the strike as possible.