More Discussion: Adjustment Point

From Jim;

Hi Mark,

If I'm short the 630/640 put spread and the index is trading at 645 then I agree it does not matter what I collected and I should just get out. But I don't know if that is actually a good point at which to adjust though or if earlier would be better.

I know that if I constantly close out positions that have a small loss then I won't make any money. I know that if I don't close out my positions at all, then one day I'll have a large loss. But there is a large gray area in between those two extremes where I don't know how to evaluate the position.

Jim,

Welcome to the real world.  If it were easy, everyone would trade iron condors or sell credit spreads.

I didn't mean to suggest 645 was the ideal decision point in my example.  Getting out earlier is definitely recommended by people I respect.  But many traders elect to do  nothing until the strike price is breached.  This is one of those very important comfort zone decisions – and no one can advise you on this. They can tell you how they do it, or how successful one method has been for them, but it's still your money and your comfort one.

There's no reason to believe any specific method is better than another.  Comfort zone and trading experience will determine at what point you can't stand the pain or when fear of a big loss takes over. [But a trader must avoid having that fear when RUT moves 10 points from the original trade.  If that's the fear point, then iron condors are unsuitable for that investor.]

You are absolutely correct.  Premature panic or rushing to exit every trade that has risk – just because the risk has increased by a small amount is not viable, and will result in losses.

Selling option premium, such as trading iron condors, is not risk-free.  Nor is it an advisable strategy for everyone.  One reason for writing option spreads that are fairly far out of the money (but not so far as to prevent collecting a decent premium) is so that adjustments are not a part of the trader's daily life.  Adjustments are costly and necessary, but they do reduce risk and are advisable.

Each trader must choose a comfort zone.  For example, if you want to adjust RUT spreads any time RUT moves to within 20 points of your short strike, then you must choose spreads that make it unlikely that RUT gets to your price any time soon.  Thus, selling spreads that are 40- or 50-points OTM won't work for you.

How to tackle the gray area is not something that anyone else can solve for you.  If you are quickly made to feel the need to adjust (BTW, you can close 5 or 10% of your position as a first adjustment, no need to close them all), then perhaps the underlying asset is too volatile for you.  Consider choosing another – for less risk and reduced profit potential.

It takes time to work out how much risk you can afford to take.  It takes time to decide how much size to trade.  It even takes time to find the right underlying, assuming you choose not to trade individual stocks.  Have some patience. 

One more suggestion:  It should be a longer-term goal for you to trade this type of position.  Don't let the fact that the result of a specific adjustment turned out to lose money have any influence on your future adjustments.  Markets will reverse after you adjust and they will continue to move against you if you fail to adjust.  That's the way it is.  Try to have a consistent pattern and trade within your comfort zone – even if that means remaining with one-lots for now.

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8 Responses to More Discussion: Adjustment Point

  1. Jim Lindor 01/30/2009 at 10:06 AM #

    Thanks Mark.
    It is difficult for me to pick an exit point when I don’t have any basis for picking one point over another. But I do understand that picking a point is necessary and I will come up with something.
    In your book you mention close to the money condors. What range of deltas would be used in a CTM condor?

  2. Mark Wolfinger 01/30/2009 at 10:11 AM #

    CTM is a relative term.
    To a friend who trades them, he goes 20 point OTM in RUT.
    For me, I’d say that collecting half the maximum premium is CTM. That means $5 on a 10-point iron condor.
    There are good reasons for owning CTM IC positions, but they me me uncomfortable, so I avoid them.

  3. Justin "The Night Trader" 01/30/2009 at 11:35 AM #

    One thing that I have found to be very helpful in all of this is to virtual trade my strategies before taking them live. That way you can get a good feel for your comfort/risk zones without risking real money. Once you get a good feel you can confidently take your trades live. I’m currently working on writing a 3-part article on virtual trading for my blog, so keep an eye out for it if you want more information.
    I’m currently using virtual trading to learn ICs. So far only 1 trade so I’m really new :-). It’s been interesting watching you trade Mark. I’ve been tracking your Twitter updates.

  4. Mark Wolfinger 01/30/2009 at 11:57 AM #

    Justin,
    I agree that paper trading is a good idea for most investors when trying to learn something new. The only problem occurs when investors fail to take the trades seriously because real money is not at risk.
    But for the majority, those with the right attitude, virtual trading works.
    Keep in mind that most traders of iron condors prefer positions with nearer expiration dates than the ones I post on Twitter.
    One trade is one trade. Soon it will be many more. Best of luck.

  5. Justin "The Night Trader" 01/30/2009 at 12:05 PM #

    I totally agree about people taking their paper trading seriously. That’s one of the major points I’m making in my article. I’ve seen too many people setup a million dollar account and go wild thinking they’re getting practice! The other caution I have is not being able to 100% simulate a market maker. No matter how good your virtual trading system is you will have different fills with live trades.
    OK, that answers one of the questions I had. Personally I’ve been looking at trading front-month ICs, which is how I did the 1 trade I’ve done. I think if you catch the IV right, you can still make a good percentage (at least I did last month 🙂 ). But I always like seeing different angles from other traders.

  6. Mark Wolfinger 01/30/2009 at 12:25 PM #

    You can never simulate a market maker because you cannot buy at the bid price or sell at the ask price on a consistent basis.
    And don’t forget – the brokers want you to graduate from paper trading. Thus, some make it easier to get your orders filled – fills that you would never receive in the real world. That’s deceitful and fortunately, not all brokers do that.
    Front month has much faster time decay – the good news. It also has a lot more negative gamma, and that’s the bad news.

  7. piazzi 01/30/2009 at 5:44 PM #

    we all play a game of probabilities. depending on the size of my position, and my tolerance towards risk, in situations like this, I consult the charts, and see what probablities I would give the stock to reach a certain area. e.g I look for a recognizable pattern, I try to determine degree of oversold/overbought on multiple time frames, I study the price/volume pattern, I try to apply Elliott Wave, etc. Still if I cannot really come up with any probability model, I tend to usually err on the side of caution

  8. Mark Wolfinger 01/30/2009 at 6:12 PM #

    There’s plenty of money to be made over the years. But only if we stay in the game. Caution deserves to be the winner. Good choice.