My oft-stated belief is that it is almost impossible to become a successful options trader without becoming a skilled risk manager.
When it comes time to decide how to reduce the risk of holding a position, there are many choices. The alternatives are too numerous to describe, however, the basic choices are
- Do nothing. This is not risk management. This is wishful thinking
- Adjust the trade to reduce risk
- Cut position size by exiting all or part of the position
The best decisionI believe that adjusting the trade represents the best choice, with the following stipulation: Once the position has been adjusted, the trader likes what he/she owns; believes it is likely to earn profits going forward; is no longer too risky to own, and satisfies the psychological needs of the trader. That last phrase simply means that it is comfortable to own the position and is not being held for the sole purpose of recovering a loss.
When it comes to adjusting, there are always going to be alternative trades from which to choose. Today I want to discuss one specific type of trade. I know that many traders like to adopt the example that I’ve chosen to highlight Despite that fact, I believe it is the worst possible choice.
The worst choice
Assumptions: We opened an iron condor position and the market has declined to a point where the put spread has become worrisome. For this discussion, it doesn’t matter whether the put spread is 5% OTM (far too early to be concerned in my opinion); 3% OTM or ATM. The point is that the underlying asset has moved to a point at which the specific trader who made the trade is uncomfortable holding the position as is, and wants to make an adjustment.
Let’s assume that the position is long 300 delta.
There is one adjustment method that I avoid discussing – just to minimize the possibility that it would occur to any reader to experiment with this trade idea. Keep in mind that the ONLY reason for making an adjustment is to reduce risk – as long as the new position is worth holding. We do not reduce risk to crate a position that we do not WANT to own.
So what is this adjustment that I think is so terrible?
It’s the sale of call spreads to add some negative delta to the portfolio. (Or put spreads when the market has been rising and the portfolio is delta short.) Selling call spreads accomplishes some noble goals: It move the position nearer to delta neutral. When trading with no market bias, that’s a good thing. It also adds more cash to the trader’s account, increasing the potential profit, and we all like to earn more money.
One other benefit of adopting this strategy is that it seems to work so often. Much of the time the market continues to drift lower, making this adjustment profitable. Of course the put situation has gotten worse. That’s not a real problem when the trader is on top of the situation and is taking steps to manage risk. However, all too often the steps taken include the sale of even more call spreads. Once again, taking in cash and reducing the immediate delta risk.
I must admit that this strategy works very nicely when it works. Sometimes the cash from the call sales is sufficient to cover all losses from the put side of the iron condor and the trader may eventually earn a profit. Sometimes the market stops moving lower and the trader not only earns the original cash collected when initiating the iron condor trade, but is rewarded with extra profits derived from the call sale.
That’s the good news.
However, the primary (if not the only) purpose of making the adjustment is to reduce risk. This method does reduce delta risk (temporarily), but it adds negative gamma and a significant downside risk. when selling those additional call spreads, too often the trader sells a cheap spread (so it is reasonably far OTM). That does notr add very much cash to the kitty, and adds major risk of loss – if the market turns – for very little cash. If the trader makes the better (but still terrible) choice of selling calls spreads that generate a ‘decent’ amount of cash, then there is at last a reward worth earning for taking the risk.
But that’s the point. Adjustments are risk-reducing trades (or should be). The idea that lessening delta risk makes for a good adjustment is not the way a successful or experienced executes adjustments. I understand how powerfully profitable this plan looks. But it only takes one large and sudden market reversal to blow up an account with far too much loss exposure.
But there are two potential disasters that await. I believe that the sole purpose of adjusting a position is to reduce risk – not to seek extra profits. [I am not against earning extra profits, but the primary purpose is to make the current position safer and worthwhile to hold.]
When extra call spreads are sold,nothing is done to reduce the risk presented by those put spreads.
Problem number One: If the market continues lower, the loss form the puts is going to increase rapidly. The sale of call spreads is not going to generate enough cash to offset these losses. Thus, the primary purpose of making an adjustment – to keep risk of loss at a reasonable level. Once those puts move into the money, it becomes far more difficult to manage the entire position. Not only are the put spreads problematic, but the continuing sale of call spreads can result in blowing up the trading account if there is a sudden market reversal.
Problem number Two: When keeping risk in line is not the MAJOR (it should be the only) consideration when making an adjustment, far too often risk builds and goes unnoticed. The type of trader who employes this ‘sell more calls’ method of risk management seldom bothers to buy back those now, far OTM call spreads. It’s bad enough to create downside risk – where none existed before – but to not buy back the cheap options creates a scenario in which a traders account can disappear overnight.
This is unacceptable risk (Obviously an pinion and not a statement of fact). But it is a tempting methodology. It works most of the time. It can lead to extra profits. It’s easy to fall in love with this strategy. But good luck does not hood forever. Markets do get volatile again, and despite promises that the trader makes to him/herself to act in plenty of time – f necessary – the personality that sells those extra spreads to bring in more cash – is not the right personality type to be able to rush in to cover those call spreads when the market turns. In fact he sale of additional put spread would probably be the trade of choice.
This is a disaster waiting to happen. I feel it is the worst possible adjustment chocei and would go as far as to say that if you are considering this play – selling more calls without buying back the original call position – it’s better to exit and take the loss, rather than to build risk to unacceptable levels.