Adjusting an adjustment

September and October are behind us.  There was no market collapse and those who paid high prices for VIX futures contracts (or options) lost money on their expectation of a substantial increase in market volatility.

The holiday season lies ahead, and that is often a period of reduced market action and volatility.  Has complacency arrived?  Is now the time for unexpected market moves?  Who knows?  What I do know is that paying careful attention to position risk continues to be the name of the game.  Keep alert. Avoid the large losses and survive.  That's goal #1.  Find appropriate strategies and prosper – that's goal #2.

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Adjusting an adjustment

Let’s say you sold some call credit spreads (either as a standalone trade or as half of an iron condor) before a market rally and that your position became delta short as the market moved higher.  Let’s also assume that you bought 5 Nov 350/360 INDX (a fictional broad-based index with Europeans style options) call spreads to offset a portion of your upside liability.  The original position is probably 25 to 50-lots if this 5-lot is to be consiered as an early (Stage I) adjustment.

Unfortunately (for you), the market continued to rally and you make another adjustment (or two).  The position is still viable, but if INDX moves another 3% higher, your plan is to exit the trade and re-invest your money in a better position.

However, right now that 350/360 spread you bought has done well, and can be sold @ $8. It seems obvious to adopt this thought process: My complete position has upside risk and I need all the protection I can get.

To a point that's true.  However, the cost of that protection must be considered.  From my perspective, paying $8 for a spread that may, if the market doesn't tumble, be worth $10 when expiration arrives is a poor choice for gaining some upside protection.  You, the trader, want to own protection that can earn more than 25% of its cost and which has some positive gamma.  There is nothing to be gained by buying more of these $8 spreads.

However, my suggestion is consider selling this call spread.  First, it affords little protection.  Second, if you sell that 5-lot and collect $4,000, you can accomplish two good things for your portfolio:

  • Take out some cash
  • Reinvest a portion of the proceeds from the sale and buy different protection

Counterintuitive

The idea of selling a call spread when you are already short delta seems to be a big gamble.  However, I encourage you to look at it this way:  These five call spreads offer a maximum gain of $1,000 and that's not nearly enough to make much difference in the future value of your portfolio.

Note:  If your original trade is 25 to 50-lots, as suggested above, then you can afford to forgo that last $1,000 from the adjustment.  But more than that, you may be able to get better protection.

Example

Original trade: Sell 40 INDX Dec 380/390 spreads when INDX was 320.

Adjustment One: Buy 5 INDX Dec 350/360 spreads when INDX was 340

Adjustment Two: You bought 5 Dec 370/380 spreads when INDX was  360

At this point, the 350/360 spread serves little purpose.  Think about 'adjusting the adjustment' by exiting the 350/360 spread, collecting between $8 and $8.50 per spread.  Make another adjustment to the main position – if you find something suitable to do.  If you find nothing attractive, hold and decide when to exit.  This position can become very costly if you don't exit in time.  However,  the original 5-lot adjustment no longer affords any reasonable upside protection, making it a good idea to sell and look for something better.

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6 Responses to Adjusting an adjustment

  1. zoeisabelolivia@gmail.com 11/01/2010 at 4:13 AM #

    Thanks for the blog Mark. It’s just great. I wonder if you can give some advice? I set short straddles usually 30-45 days prior to expiration on the spx index most of the time at the current market price. What do you think is the best option strategy to use to offset large moves up/ down? Say I set a Dec straddle Monday Nov 1 at 1185 for 60 points in premium. I feel that a large downside move may occur that could take prices 10% down from 1185. Would buying a straight put (or a bear out spread?) be best? It’s an expensive route to take and just wondering if you have another solution?
    Thanks.

  2. Mark Wolfinger 11/01/2010 at 7:03 AM #

    Zoe,
    The truth is that selling straddles is a strategy that seeks a very high profit. Thus, it comes with significant risk.
    The best (in my opinion) protection is to buy a put that is farther OTM than your short put.
    I’ll provide a more detail reply tomorrow as a separate blog post.
    Regards and thanks for the kind words.

  3. Fran 11/02/2010 at 12:55 AM #

    Hi Mark,
    what about transaction costs with all this adjustments?
    The best strategy (in my opinion :-)) to use when adjusting positions is reduce position size, because in the long run, transaction costs are another risk to save and a big difference in your trading performance.
    Regards

  4. Mark Wolfinger 11/02/2010 at 8:15 AM #

    Hello Fran,
    I never object to size reduction as an adjustment. However, making adjustments can increase both the likelihood of earning a profit and the size of the profit. That is not something to be ignored.
    Yes, transaction costs are important – and that’s especially true for those who trade one- and two-lots. I’m not sure how costly commissions are where you live (Spain?) but US traders can find brokers with very low commissions.
    Regards

  5. Fran 11/02/2010 at 9:12 AM #

    Hi Mark,
    I’m trading with Interactive Brokers from Spain 😉 Luckily, location is not a trouble today.
    The question here is: if you have a trading edge (checked), how does your adjustments bias affect this advantage? Have you test it?
    Hard questions to answer for a lot of options traders, but you can be sure that cutting costs you are not eroding your edge. You must manage your risk with low cost trades. Here less is more.
    Regards from Spain
    (and excuse my English)

  6. Mark Wolfinger 11/02/2010 at 9:49 AM #

    Fran, your English is excellent.
    1) You are using an inexpensive broker and that helps reduce trading costs
    2) I admit that I do not worry about ‘edge’ when making an adjustment.
    I have only two concerns:
    a) Does this adjustment trade give me a position I want to own? Do I like the profit potential and the risk?
    b) Does this adjustment trade truly make the position less risky? Have I reduced the probability of losing money (from today into the future)? Is the amount at risk (worst case scenario) acceptable?
    If both of those conditions are met, I am willing to pay commissions to make the trade. After all, reducing or exiting also involves trading expenses.
    As to ‘edge’: I will not make a trade that I believe adds negative edge. I will not hurt my position by making it worse that it is right now (when an adjustment is needed). I prefer to take the loss and find a better position to own than to add negative edge to my current position.
    Fran, Much of this is art vs. science. It’s also a matter of personal comfort. Not every trader is willing to accept a loss (but every winning trader understands that it is necessary), and often makes bad adjustments – just to keep hope of earning a profit alive.
    Good discussion. Thanks.