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Roll a Position: A Risk Management Tool

When trading, risk management is an essential skill. There are many ways to control risk and it is difficult (if not impossible) to compile a complete list. However, at the top of the list is one easy-to-understand concept: Position size. That means that traders should always be aware of what can go wrong with every position and be certain that your account can survive the worst-case scenario.

Roll Strategy

One very popular strategy for handling a position gone awry is the “roll”.

Rolling occurs when a trader covers the existing position and sells another position. The new position resembles the first — but the strike price of the option(s) and (sometimes) the expiration date change.

Rolling is used to avoid closing the position and taking a loss. However, it is necessary to understand that some positions cannot be saved. Thus, be prepared to exit and accept a loss whenever you cannot find a suitable roll. Translation: If you cannot roll the position into one that you truly want as part of your portfolio, then do not roll. It is always a bad idea to create a new position that does not fit within your comfort zone.

Rolling is a good technique when the trader understands how to manage risk. Too often position size increases after the roll. In general, creating a larger position is a bad choice because the money at risk also increases.

Here are a few articles that I recently published at about.com. Each discusses one aspect of rolling a position.

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Introduction to the Greeks

The Greeks are easy-to-understand (honest) tools for measuring risk. You, the trader can delve into the math or you can accept the numbers generated by your broker’s (or use another source) software.

The basis of risk management is using the numbers to control the possible gains and losses from your options trading.

At my about.com site I just published a string of articles for newer option traders:

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Risk and Position Size

My latest blog post at options.about.com is all about risk, including a definition and recommendations for choosing an appropriate position size for each trade.

2nd edition cover

2nd edition cover

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Position Size and Cash at Risk

Hi Mark,
I am still having a hard time determining IC risk and therefore the the initial position size. Let’s say that I don’t want to risk more than $2,000. if I take a position that has a maximum loss of $2,000, it wouldn’t reflect the true risk because adjustments are planned and the position is unlikely to reach the full loss. Thus, I would be trading less than my optimum size.

I plan to exit when no more adjustments are justified and the current loss is approaching my mental money stop level, $2,000. But I don’t know in advance what adjustment(s) will be made, how much cash they require, whether I will have chance to roll-up the winning leg etc. So how do I determine how many lots to trade?

I currently trade 4-5 LOTS of a 10-point RUT iron condor, and I’m comfortable with that. However I have no idea how to size my trades when the iron condors are very different (one week expiration or high-delta, high premium ICs).

When you own stock – and it moves to a certain price (your limit), you know that the stock is not behaving as expected and the position is closed.

Option trading is similar when the underlying makes an unfavorable move. We exit the trade.

However, there are situations unique to options. We may have a loss, but our instincts may tell us to own MORE of a given trade at the current price. Good discipline prevents us from adding to the trade, but it doesn’t feel right to exit. This occurs when we are short vega, as with an iron condor, and implied volatility rises. The stock price may be unchanged, our position may be very near delta neutral, but we are losing money due to being short vega. I would not exit the trade and I do not believe this is a lack of discipline.

When trading options we must look at more than how much money has been lost. We must consider current risk, the reason for the loss, and the future prospects for the position.

Note: You cannot decide that you love the price just because the credit is larger than the initial trade. You should not be trading market-neutral strategies and decide that it is okay to hold a very non-neutral delta position. That is why sticking to strict limits when trading options, such as 1-2% of the portfolio value, is more complicated than when trading stocks.

I am NOT suggesting that you take extra risk. Buy you will not always know the price point for exiting in advance.

As you indicated, we do not know how the trade will play out or whether any adjustments will be made. But those adjustments affect the final profit/loss numbers.

When an adjustment is made, be flexible. Here is how I look at this situation:

When I buy a 3-month iron condor and collect $250, I plan to exit and take the loss when it costs ~$500 to $550 to cover the position. Maximum loss is $250 to $300 per spread. I would feel comfortable trading 7-lots when my maximum acceptable loss is $2,000.

How well do you like the trade?

All spreads are not created equal, so do not trade maximum position size for each position. Assuming that some trades look far better than others, Instead of always trading 7-lots, I would trade 4 to 7 lots, with an occasional 8-lot when the trade is especially inviting.

Allowing for an adjustment

When making an adjustment, I pay a cash debit by rolling down. For conservative investors who do not want to lose more than the specified amount I suggest reducing the buy-back price so that the total loss does not exceed your target. Thus, if it cost $125 to roll, then I would plan to cover when the spread reaches $400 to $425. [+$250; -$125; -$400 and the loss is $275]. I would still trade the same 7-lot as my optimum size

the aggressive trader can think this way:

    –I can adjust or exit when appropriate.

    –If I deem the spread good enough to adjust, then I treat it as a new position and plan to cover at that same $500 to $550 for the whole iron condor. Yes, this increases my maximum loss for the entire trade, but an aggressive trader sees it this way:

    An extra investment was made because the position was deemed worthy, and the adjusted IC is treated the same as any newly opened position.

A lot of this is determined by the trader’s mindset. So rather than focus on exactly how many to trade when opening the position, be more concerned with which risk-management plan feels right to you and your comfort zone. You can limit losses and seldom get into trouble. Or you can be less conservative and invest more money when the position looks attractive.

I’ve used a lot of words to say that holding option positions is not similar to buying (shorting) stocks or futures. Time decay and volatility are unique to options and there are going to be situations in which money has been lost but a position is still worth holding. Violating stop loss prices with stocks shows a complete lack of discipline and must be avoided. When a stop price is reached for an option position, do exit when the loss is due to market movement. However, if the loss comes from a big change in implied volatility, there may be some justification to hold longer. Good judgment is required. As a result, we may discover that we incur a loss that is a bit beyond out limit.

The Rookie’s Guide to Options, brand new 2nd edition. Revised and expanded.

2nd edition cover

2nd edition cover


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Important Post for Spread Traders

At times, when being taught something new, the teacher may fail to mention something because it is so obvious. That may cause significant harm to those who require that the obvious be pointed out to them. I remember my own struggles with trigonometry until a friend presented me with an ‘aha moment’ by showing me something (long forgotten now) that made all the difference. After that moment, trig become a snap.

For the majority of new option traders, this lesson is unnecessary. For others it can turn spread trading from something mysterious into something simple and profitable.

THE KEY: A spread is an entity unto itself and the individual options that comprise the spread can be ignored.

Example 1

    If you buy a call spread, do not sell the option you own when it can be sold at a profit. There is no profit. In order for the spread to be profitable, you must sell the whole spread for more than it cost.

Example 2

When trading iron condors: (the iron condor is the sale of one call spread and one put spread on the same underlying asset when both spreads have the same expiration)

    The put spread is not sold to make money.
    The call spread is not sold to make money.

Instead, the iron condor trade is made to make money and that requires covering both the put and call spreads for less than the premium collected.

The put spread is sold as a hedge against being short the call spread. Translation: If we lose money on the call spread, we recover some of that loss by being short the put spread.

The call spread is sold as a hedge against being short the put spread. Translation: If we lose money on the put spread, we recover some of that loss by being short the call spread.

We plan to make money by covering the iron condor position (not only one half of it) for less than the original premium collected, after time has passed and the stock has behaved (traded within an acceptable range).

This may seen trivial, and it is — once it has been learned. However, we were not born knowing this and it is something worth mentioning. I have seen too many iron condor traders cover the put or call spread when it became profitable, and thereby lost the advantage of owning an iron condor position.

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Trader Mindset: The Cost of an Adjustment

The setup

A trader buys (or sells if you prefer that terminology) an iron condor, collecting a cash credit of $250. The market moves against the position and the trader decides that he/she is no longer satisfied with the trade. Something must be done. Keeping this discussion simple, let’s say there are two choices.

    a) Close the trade, paying $400 per iron condor. Net loss $150 per
    b) Adjust the trade

  • Define adjustment: Change the position to reduce risk
  • Necessary condition: The new position is ‘good.’ The trader wants to own it
  • The adjustment is NOT made to avoid taking a loss. It is made to reduce risk

Adjustment cost

When the adjustment requires a cash outlay of $50 to perhaps $200, most traders are willing to protect their remaining assets by making the risk-reducing adjustment.

However, if the adjustment requires paying $300 – $350, there is resistance to the idea.

One of the Gold Members at Options for Rookies Premium made the following comment regarding such an adjustment:

I’m not sure I could spend more on my adjustment than I received; that might be tough.

A significant quantity of traders are predisposed to some ideas (mindsets or mental blocks) because they seem so obvious. The logic behind their reasoning appears to be so impeccable that it ‘s essentially inconceivable that the ‘obvious’ belief can be erroneous.

The quote above represents one such example.

The truth

Without an adjustment, the risk of losing too much money has become unacceptable for this trader.

These are the facts, although not everyone is willing to accept them:

  • The iron condor is no longer priced at $250. The current market value is $400
  • Making trade decisions based on the $250 price cannot be efficient because it is not a realistic price

Additional facts, based on the trader mindset:

  • Trader is willing to spend $400 to exit the trade
  • Trader is unwilling to spend $300 to make the trade, even though the new position would be:
  • Safer to own, with risk of additional losses significantly reduced
  • Less dangerous to own because amount that can be lost has also been reduced
  • Good enough to own. That means the trader would be comfortable establishing it as a brand new trade

Bottom Line

Trader is willing to exit, spending $400 because taking losses is sometimes necessary.

Trader prefers not to spend $300 to build a better position that offers a good return in exchange for the risk involved.

Why? Because spending $300 results in a owning a position when the bookkeeping says it can never be profitable (based on the original entry price). The excellent chance of earning money from today into the future is ignored.

When thinking about the cost of adjusting, that decision should be made between the current choices, and has nothing to do with the original price at which the trade was entered. The choice is: exit and pay today’s price; or adjust and pay today’s price. Make the better choice by making the better trade.

That’s the path to success.

995

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Position Adjustments are Essential

Mark,

Let us take two traders (A and B) trading ~90 day index ICs (or credit spreads) with a preference to exit the market 20-30 days before expiration. These traders make exactly the same trades and have the same comfort level and same trading philosophy, except when it comes to making an adjustment:

Trader A always uses the same adjustment method: close all positions at the same time or close in stages.

Trader B sometimes closes his positions and sometimes he uses other adjustment methods depending on his analysis in each situation.

In the long run, and under all kinds of different market conditions, I think trader B will achieve better results (higher annualised returns). The question is how much better?

Obviously, I am not looking for precise figures here, just some kind of rough data/information/comments that could help me decide for myself, if it is worth it (for me) to spend the necessary time to “master” one or more of the available adjustment methods.

Thank you,
Dimitrios

Good question. However, the problem is not with ‘learning’ something new. Nor does it have anything to do with your ‘mastering’ anything special. We must look at ‘adjusting’ differently.

As to the final question, I believe that knowing how to ‘fix’ a good, but risky, position is a powerful earnings source. It remains important to exit trades that are not worth salvaging.

An Alternative Perspective

I often refer to ‘risk management’ as if it were separated from ‘regular’ trading. We enter into a trade as a first step, then when necessary, the original position is changed or adjusted.

Consider this perspective:

You own a blank portfolio – with no current positions. No risk. No possible reward.

Next, assume adjustment to that portfolio is made. Deciding that zero risk/zero reward is not what you want to own right now, you buy an iron condor. That trade adjusted (changed) the portfolio. You made a voluntary trade and added an acceptable level of both risk and reward potential.

    I’ve described adjustments as having one purpose: risk reduction. In this scenario, the risk of having no earnings potential was reduced.

Two weeks later, you make another portfolio adjustment by opening a new position. Perhaps it’s a butterfly spread this time. This is another voluntary portfolio adjustment.

Most traders think of an adjustment as involuntary. In other words, they prefer not to make that trade. That is not a good mindset, and only applies when the trader has waited far too long and now has no alternatives, other than exiting the trade. I suggest looking at an adjustment (as it is usually defined) as a voluntary trade. You want to make this trade because it reduces risk and transforms the current position into another that you want to own.

From this perspective, making a position adjustment is NO DIFFERENT from opening a new trade.

When the adjustment is complete, you own a position that you want to own. Isn’t that exactly how you feel when making a new trade?

Thus, you do not have to ‘master’ anything. You only have to know when an adjustment is needed and recognize when a new trade is going to give you an improved position. I believe those are reasonable goals for any trader. Think of ‘adjusting’ a position as working on a partially painted canvas, whereas adjusting a portfolio by adding a new trade is working on a blank canvas.

Just as you make an effort to learn more details about trading your chosen strategies, so too will you learn a few possibilities for ‘fixing’ a troubled trade. There’s no need to be any more of an expert in making these trades than there is in making the original iron condor trade. It may be more fun to open a clean trade, but you will discover that the money is made by improving your positions. I do not believe there is any special edge in initiating iron condors. The edge has to come from good decision-making, and trade execution skills.

As you understand more about options, you gain a better intuitive feeling (but do NOT ignore the risk graphs or the greeks) for which trade type provides needed (even if not the absolute best) risk-reducing, profit-enhancing protection. It is worth the effort.

If you believe than an adjustment is another profit-making opportunity and not a nuisance that locks in a loss, then the whole idea of adjusting becomes so much less frightening and burdensome. It’s just an ordinary trade using options = to do what options do best: reduce risk and (if you elect not to exit) increase the chances of owning a winning trade(defined as making money from the time the adjustment is made).

990
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Trader Mindset Series: IV. Adjust or Exit?

Locking in a loss

We all know that taking losses is necessary and we all prefer not to do that. However, one of the most costly mistakes that traders make is refusing to take a loss when

  • They no longer like the position
  • The trade has become too risky to hold
  • The trader’s maximum loss for the trade has been reached

Consider these scenarios:

    Exit or Adjust

    Scenario a) A trader is managing a position that is moving against her. Let’s assume the position is a put credit spread and her underlying asset is moving lower. Not at the stage of capitulation, she makes a well-judged adjustment. Next, the underlying moves lower aggressively, and the risk is more than our trader is willing to accept. The adjustment has helped, but not enough. The position is closed. The loss is accepted as the cost of doing business and she is already looking for a good opportunity for her next trade.

    Scenario b) Some months later the same trader finds herself in a similar situation, but this time she is short a 10-point call spread (sold, collecting $200) that has become too risky to hold.

    She has two choices: The first is to pay $400, take the loss and eliminate all risk by closing the position.

    Alternatively, she sees a decent adjustment. More than that, it looks to be a good trade. It eliminates the possibility of a large loss, although money is still at risk. This adjustment requires an outlay of $300 to execute the trade. That’s uncomfortable because that’s more cash than she received when selling the call spread.

    Our trader thinks about this and decides that making the trade would be foolish because once the $300 is paid, she would own the position at a $100 debit, still have some risk, and would lose money (all options expire worthless) if the market moved lower. That could easily result in all options expiring worthless.

    The position is closed (by paying $400) and the adjustment idea is discarded.

True Story

This scenario occurs in the real trading world. I’ve received several comments/questions on this topic from both readers of this blog and Gold Members at Options for Rookies Premium.

It’s a realistic mindset because traders behave just as our trader did. Whenever an adjustment costs more than the original trade credit, it is abandoned. I hope to persuade you that this is a losing mindset by making some points that I have discussed previously in this blog.

But first a clarification: The discussion below assumes that the adjustment is good and needed. It assumes that the adjustment is not made with the sole purpose of avoiding an exit that locks in a loss. This is a very important point., Many traders adjust just to stay in the position. Do not depend on good luck to protect the assets in your trading account.

1) There is nothing wrong with exiting when you are uncomfortable with a trade. Thus, the decision to exit is always acceptable

2) When you have a choice between two reasonable alternatives, to find success over the long term, it’s important to make the trade that leaves you with the better position – but there are conditions

  • The final position must be one you want to own at the price paid
  • If the condition above is not satisfied, then choose the exit
  • The adjusted position must be within your comfort zone regarding risk and potential reward (from today into the future, not from the original trade price)

3) Why did our trader choose to buy back the original trade, paying $400 instead of making a good adjustment and paying $300? Answer: Because of a losing mindset. It is not uncommon for new traders to believe certain ‘rules’ with no idea how those rules originated.

There is nothing wrong with paying more for an adjustment than you collected for the original trade. Assuming a trade must be made for appropriate risk management, then the true decision is:

Would you prefer to buy the position sold originally at its current price? Or would you prefer to make the adjustment at its present cost? You cannot do both. It’s edit or adjust.

Repeating for emphasis: The original trade price must play no role in this decision. You have a position – at today’s price. Nothing can be done to change that. You must exit, adjust, or do the unthinkable, and take more risk than your account (and psyche) can handle.

Do not foolishly throw good money after bad trying to salvage junk. But do not be afraid to make a solid investment that improves your chances going forward.

989
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