Naturally, we are in the camp where we believe, and our backtesting confirms, that rolling your strike prices closer to where the stock is trading and taking in additional net credits ultimately gives you the best opportunity to either profit or reduce risk on the position. On today's podcast we'll explore this topic more deeply with a very detailed example and walk through so you understand conceptually how it all works moving forward.
Key Points from Today's Show:
- When you roll up your strike prices, you are collecting more credits.
- This moves the unchallenged or untested side of the trade closer to where the market is.
- Taking what the market gives you and adjusting along with the markets as they move.
If the stock is trading for $100 and starts to run up to $105, you would roll up your puts, which are below the market. If the stock is trading at $100 and starts falling to $95, roll down the calls closer to where the stock is trading.
Why Adjust Instead of Closing Out?
- When adjusting a position without adding any additional risk, you take in more credit.
- The credit widens your break-even point on your challenged side.
- If those break-even points are ever breached, then at least you have effectively reduced risk.
- An adjustment reduces the loss that you might have on that particular side of the trade.
- This cuts the trades loss profile, creating an unintentional win.
*Myth: the trade you start with is the exact same trade you end with.
That is only true if you never make an adjustment.
Example: If you start with a strangle, that doesn't mean you end with a strangle. You could potentially adjust the trade into straddle. So if you have a trade with a 70% potential chance of success to start with and the potential to lose $500, the goal is not to lose the maximum amount. It's always to adjust into a position to cut the loss. This is another way to break the zero-sum cycle.
A stock is trading at $100. You sell the 95 puts and the 105 calls to create a simple strangle position. Next, you sell the strangle for a $2 credit, so you collect $200 of premium. This moves the break-even points on either end to 93 on the put side and 107 on the call side.
Next, the stock starts to rally higher, all the way up to 104. If you are still 2 or 3 weeks until expiration, roll up the short 95 put options to the $100 strike price where it was originally trading. The only side of the trade that is generating money is the put side. Say those puts now have decayed in value to $20, or 20 cents of the option premium. They have gone down in value because the stock has run up, which is ideally what you want when selling naked puts.
Then, you want to close out of the put options, roll them higher to the $100 strike because the $100 strike is going to carry more premium than the 95 puts. It's much closer to the stock, has a higher chance of going in the money, therefore it has more premium. By rolling up, you are closing out the 95 puts, buying them back for 20 cents, and then resell another put option at the $100 strike. This transfers the position from one strike to another.
Now, you can sell the $100 strike put options for 80 cents. You can no longer sell them for the original dollar and you are closer to expiration. The net credit that you collect in this case is 60 cents between the buy and the sell. This is considered an additional net credit to your original position.
At this point, you have the 100 strike puts and the 105 strike calls and the stock is trading at $104. This time the credit you have taken in is a total of $2.60. This moves the break-even point on the call side from 107 up to 107.60. By rolling up the put side and adding the additional credit you are now moving the range on your call side break-even up by the amount of credit taken in. The credits may allow you just enough wiggle room to be profitable in the position, which is the main goal.
Now, the stock is trading at $104, you are still leaving room for the stock to come back down. Adjustments get more and more aggressive as you start getting close to expiration. Three weeks out from expiration, you want to make an adjustment but still, leave room for the stock to come back down. If the market does challenge you, make an adjustment but leave room for the market to ebb and flow.
The market continues to move aggressively against your position. From the 104 strike, it moves up to the 107 strike. Now it's right on the doorstep of your break-even point. A week out from expiration, you are now at a break-even point. But because you rolled up your original puts from 95 to 100, you still have 60 cents of room for the stock to move and still make money on the position. The profit will not be a lot, but there is still room for the position to generate some income.
At this point, you can start to be more aggressive by rolling up your put options even further. The options on the call side are in the money, not yet at risk of assignment on those contracts. Now you can buy back your strike put options for 20 cents. Can also sell the 105 calls for 60 cents. You are now able to sell for less and less credit as you get closer to expiration. Rolling up from the 100's to the 105 puts will give you a net credit of 40 cents.
This net credit gets added to overall premium and credits collected, for a total of $3 in overall credit, moving break-even point $3 from call strike price, adjusting the break-even point out to 108. Now you have the straddle at 105 for the month of expiration. This leaves another $1 that the stock can move before we actually truly start losing money after all the credits that you received.
- Adjusting the unchallenged side of a trade allows you to move the break-even point.
- When the break-even point is wider, it gives you more room to potentially make a profit on a losing trade.
- Making an adjustment allows you to collect more premium, increasing net overall credit.
- As you get closer to expiration, be more aggressive with your adjustments still leaving room for the market to move.