You've entered a new option trade with a high probability of success - but you also know that a 70% chance of success doesn't mean it's a sure thing. As soon as your order fills the stock starts to move against your position - just your luck, right? And each subsequent day the stock continues to trend closer and closer to your strike price, threatening your position. At this point, you're starting to get pretty emotional about the whole thing and don't know what to do or how to adjust it.
When do you pull the trigger and make an adjustment? Do you do it now or is it too soon? If you wait, what if you miss an opportunity? How much time is left until expiration? Are you taking in enough of a credit to reduce the overall risk? Is it worth it to even adjust at all right now?
Believe me, I get it, and I know that these are just some of the questions circling in your head when presented with this situation. That's why in today's podcast episode I'm going to take you through three specific triggers you can implement right now to help you start making smarter, more unemotional option trade adjustments when a stock starts moving against you. You'll also hear why I favor trigger #1 over the others as it's a more mechanical and systematic.
How do you know when to adjust positions?
- There are many different ways to adjust positions.
- Need to lay the groundwork to set triggers in advance in your trading platform.
- This allows for unemotional trade adjustments.
- Creates a framework and process to give clear guidelines on how and when to adjust positions.
1. As a trader, most of your attention should be on the trade entry.
- Most of the emphasis — your focus, research, and analysis — should be allocated to the trade entry.
- Example: using the right strategy, setting it up for a high probability of success, checking the position size.
- It is more important to get the trade entry right than it will ever be to get trade adjustments right.
- A bad entry will not be saved or turned around through adjustments.
2. Adjustments are 100% focused on reducing risk first, not increasing profits.
- The goal of the adjustment is to lose less money.
- A successful adjustment is one that cuts the overall loss of the trade.
Three Main Adjustment Triggers
1. The Doubling of Risk Rule
- Initial trade set up: a short strangle — a short call and a short put out of the money — at 70% probability of success, each side placed the 15 Delta.
- Only make an adjustment if one side has risk that doubles.
- Example: If the probability of losing doubles from 15% to 30% on either side, consider making an adjustment.
- Set up a trigger to alert you when the risk has doubled, to then allow you to consider making an adjustment.
- Once the adjustment is made and the probabilities have been reset, use the same doubling of risk rule in case the stock continues to perform against you, using 60% as the second trigger.
- This strategy allows you to make unemotional adjustments to reduce risk.
Why use the Doubling of Risk Rule?
- The Delta is not subjective just to stock price movement. It is a substitute for the probability of losing.
- When Delta is the adjustment trigger, it naturally factors in time decay, time until expiration, volatility, etc.
- These extrinsic factors can help ensure that you do not over adjust too early, or under adjust too late.
- Creates a level playing field across all different types of stocks and all different types of ETFs.
- For these reasons, the Doubling Risk Rule is the most favorable strategy.
2. The Breach of the Short Strike.
- Simply make an adjustment any time the short strike gets breached.
- Example: if the stock is trading for $100, you sold $105 calls and the $95 puts to create a strangle. Any time the $105 calls or $95 puts are breached and the stock goes beyond those levels, then make an adjustment.
- This strategy is based more off of the stock price than other factors.
- Naturally, it could cause adjustments that are not needed.
3. A Breach of the Long Strike.
- Example: a stock is trading for $100, you sell the $105, $110 credit call spread. Only adjust the trade if it goes against the long strike, really far out of the money.
- This strategy is less favorable because it takes a while to adjust the position.
- With this, you are basically waiting for the trade to be dead, and by that point, there may not be enough premium or credit to take it in when you make the adjustment.
- Even if using any of these three strategies, need to evaluate if it is still worth it to make the adjustment.
- Example: If adjusting the trade brings in an extra $5 of premium, is it most-like not worth it to adjust it and move in one side of the trade just to get an extra $5 before commissions.
- Is it worth taking more risk for the potential credit?
- As a barrier, need to take in at least $20-$30 credit.
- If trading spreads, take in at least $15-$18 as a bare minimum, at least enough to cover the premium in the position.
Iron Condor and Credit Spread Trades in Retirement Accounts
- If you reach the adjustment triggers, you ideally want to move the whole spread -- do not want to take on any more risk.
- Close the further out spread, sell the complete new spread a little bit closer in.
- This creates more work to close one side and reopen the other, but this helps to reduce risk.
- If you just move on the short strike, you will leave the long strike and widen out the spread which increases the margin requirement.
At-The-Money Strategies, Straddles, or Iron Butterflies
- Can adjust the positions, but want to go slower and practice more patience with adjustments.
- Leave the position on to go for a longer time period.
- Since it is already at the money, need to manage the position early and avoid having it go inverted.
- Best to close the trade out early and manage it early on, which will increase profitability dramatically.
- If you do have to go inverted, try not to go inverted by more than the credit you have taken in.
- Sold an at the money straddle at $100 — the short $100 call, the short $100 put.
- If you go inverted, move up the put to the $105.
- This $105 is now higher than the short call at $100.
- When you go inverted, the minimum that the spread can be bought back for is the width of the inverted strikes, the $5.
- Be cognizant of the total credit taken in, and make sure not to go inverted by more than that credit.