Adjusting a position: Using the underlying II

Three comments/questions from Joe raise a valuable point for discussion:

Hi Mark,

I have been trading option spreads on RUT and have now begun looking into trading options on the ES (S&P emini) or NQ (Nasdaq emini). I would like to know what you think are some of the pros and cons and your overall opinion?  Comment oneClick to read reply.


How I see it so far is that with the eminis I would get better leverage and be able to hedge with the ES emini contract.

What I like most about the S&P emini is the possibility of being able to adjust with the underlying, even outside of regular market hours. I imagine this could provide a great benefit for hedging ICs, if anyone trades this way i would appreciate any imput. Comment two. Click to read reply.


is it not viable to just short or long the SP when the short strike is hit? Thus enabling the trader to be fully covered at expiration? Comment three.



In my experience, that is a commonly used, but ineffective, adjustment method that leads to much unhappiness.  Just last week I posted a lengthy discussion of why I believe it's a poor idea to adjust a negative gamma position with stock or futures


The exception

1) Joe, when the markets are closed, it's fine to use whatever you can to make an adjustment. There is no sense getting pummelled and just sitting patiently, waiting for the market to open. If you are a true believer that getting that delta risk removed as soon as possible is important, then it is good to have the opportunity to trade futures before the market opens in the morning.  If you can set it up with your broker, you may be able to trade futures overseas.

Once the market opens, it is my belief that – over the long run – you will achieve better results by unloading those futures and substituting appropriate options to make the adjustment.  And that includes the possibility of accepting the fact that you have a loss, and closing the entire trade.  As I said, my opinion.  If you are comfortable with owning stock or futures, then do not let my opinion influence you.  I can only state that I had poor results by adjusting with underlying shares.


Fully covered

2) This is the part of your question that is most important, and troublesome:  "enabling the trader to be fully covered at expiration."

If you buy the correct number of futures when a call moves into the money, yes – you will be fully covered at expiration.  Yes, you can deliver those futures when assisgned an exercise notice on your short calls.  And if the market continues to rally, it's a bonanza for you:

a) Your long calls may also move into the money

b) Your long futures/short calls are now 1:1 and this is a long, bullish position all by itself.  It doesn't even consider the extra calls you own.

Why it is 1:1?  Because you said that it allows the trader to be fully covered. Fully covered means 100 shares per call option, or the appropriate number of eminis per contract. 'Fully covered' does not mean 'delta neutral.'

If you were to buy only enough futures to be delta neutral, then you would not be fully covered.  Far from it.  You would cover only a portion of those short options, with the quantity depending on how far ITM your shorts moved (and its delta).  Don't ignore your long calls. They now have significant delta, requiring the purchase of fewer futures contracts (this assume you are seeking delta neutral and not being fully covered).

3) i suspect that being 'fully covered' is not the trade you would make in the real world.  That's such a hugely bullish play, that to me it is an attempt to go long and 'get back' the money lost on the gap opening.  But more than that, it leaves you exposed to an even larger loss should the stock go back to where it was trading prior to the gap.

4) The real problem with your plan is that it depends on the underlying continuing to move higher.  Why would you expect that to happen?  Just look at yesterday's example.  AAPL opened much lower and then rallied.  If you had sold 100 shares for each short put in your portfolio, you would have been clobbered on the rally – in addition to the big loss suffered on the original decline.

This is not a trading technique that you should want to adopt on a regular basis.  However, my usual qualifier applies:  If it suits you, if you understand the risk and reward potential, it you would be comfortable holding the position knowing that a market reversal is going to be very expensive – then this method is suitable for you.  As I said, it's a very popular method for delta adjustment.  But it completely ignores gamma – and that's the greek that caused the loss in the first place..


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5 Responses to Adjusting a position: Using the underlying II

  1. Joe 01/19/2011 at 9:29 AM #

    Thanks for the comprehensive reply Mark, you explain the pros and many cons well. I now understand the pitfalls when trying this for ICs but cant help but think this would still be very appealing for say short strangles or straddles. To think you can salvage your losing side even at expiration when your short strike is hit by simply buying/selling the UL to even make a profit is appealing, and if it whipsaws wihout expiring ITM you still have a healthy amount of premium to offset the adverse movement.
    Can you poke holes in this please Mark?

  2. Mark Wolfinger 01/19/2011 at 9:57 AM #

    If you like the idea of trading this way, comfort goes a long way towards successful trading.
    1) You underestimate the size of the whipsaw loss
    2) You are not considering how would feel if you get whipped. This is the negative side of the psychological factors. When it works, it’s spectacular. When it fails, you do not want to suffer emotional hurt.
    3) Think about this strategy: Writing covered calls, ATM plus selling a far OTM put.
    Does that appeal to you?
    Do you like the very large time decay?
    Do you feel ok with the negative gamma?
    Are you okay with the huge downside loss potential?
    That is the position you would have if you go with the plan of buying stock to hedge the short call.
    NOTE: I am not telling you this is a poor idea. I am not telling you that it cannot work. I am merely pointing out the risk involved. It’s high risk, but it’s also high reward.
    If this is the position you would be happy to own, then by all means go own it. Nothing wrong with that. Just be certain size is acceptable.
    To be a winner, you would have to see the following: After the big initial move – the one that made you use stock to adjust, the stock price would have to settle down – at a price near the strike. Is that likely? Is that the bet you want to make?
    If ‘yes,’ go for it. If ‘no’ then reconsider.

  3. Joe 01/19/2011 at 12:00 PM #

    Valid points to consider Mark. Thanks for taking the time.

  4. best kite 03/08/2011 at 12:09 PM #

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    • Mark D Wolfinger 03/08/2011 at 12:21 PM #

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