Tag Archives | making an adjustment

Adjusting a position: Using the underlying

Mark,

I have maybe a naive question. Is it possible to make adjustments to already open positions, that might be 'in danger' of losing money, using stocks (or indexes if applicable) instead of options?

From "The Rookie's Guide to Options" I know that it is possible to create 'synthetic' positions and sometimes it makes sense to trade them.

One example: A put spread where short side is ATM (or very little out), probably too late, but at this point the put should be bought back.  Instead one might short the stock and buy a call to protect from a big upside move.

Could you please explain what are pros and cons of such adjustments.

Thanks,
Robert

***

Good question.  Let me reply by making some points

1) Yes, you can use stocks or futures or any underlying asset for adjustments.  Remember that these adjustments provide only delta (positive or negative), and do not reduce gamma, vega, or theta risk

2) Any trade that reduces risk and leaves the trader feeling comfortable with the adjusted position – is a satisfactory adjustment.  That is one of the goals of risk management.

3) Buying or selling shares is a very appealing adjustment method, but in my opinion, it's a poor idea.  Many traders use stock as their adjustment of choice, believing that 'fixing' delta is all that is needed to make a satisfactory adjustment.

Think about why the position is in trouble in the first place.  The ATM put contributes significant negative gamma to the position.  Buying, or in your example, selling, stock does nothing to reduce that gamma risk.  It does take the immediate delta risk out of play.  And that's good enough for some traders.

The advantage of using stock is that the trader doesn't have to pay for any gamma and does not have to sacrifice any theta (time decay).  After all, thinks the trader, I'm in this position to collect theta, so why would I want to make a trade that cuts my positive theta?

Answer: Because buying gamma comes with negative theta. And reducing both delta and gamma is going to make the position safer than only reducing delta.  If you – an individual decision – are comfortable with maintaining the negative gamma position, then by all means – adjust with stock.  However, I feel more comfortable reducing delta and gamma risk, rather than delta only.  There's no right or wrong here.  It's a personal choice.

There is also risk of getting whipsawed.  Although that possibility exists with any adjustment, it is especially painful when the adjustment was made with stock becasue it results in a buy high, sell low scenario.

My recommendation is that it's okay to adjust with stock when you cannot figure out what else to do – but the adjustment should be temporary.  As soon as you have the chance to unload the stock position and replace it with a positive gamma trade, that will give you a better position.  'Better' from the perspective of less risk in the future.

4) Consider your example.  You are long delta because of a short put spread.  Apparently you don't want to buy any puts, but you are considering selling stock short and buying calls to protect the upside.

Ask yourself: Why don't you want to buy puts?  Is it that if you buy the put you sold earlier that you would be locking in a loss?  Is it that puts seem to be too costly?  Is it that you hate paying the time decay present in the puts?  Is it that it feels more 'professional' to make an adjustment, rather than closing the position?

None of those is reasonable.

When you short stock and buy calls to protect the upside, you are buying synthetic puts.  Stock plus a call is the same as owing a put at the same strike as the call.  If you make the suggested trade, you are complicating a position (and raising margin requirements) for no good reason.  Buying the synthetic put is the same as buying the 'real put' – and if determined to make the stock plus call play, then I strongly recommend buying the appropriate put instead.

To answer, I cannot think of a single 'pro' for making that play , only 'cons'- unless the prices of the options are so far out of line that buying stock plus puts is a lot cheaper than buying the call (do not forget that it costs money to own stock).  The 'cons' have it.

Robert – just because you can trade a synthetic (or equivalent) position, it does not follow that it's always a good idea.  Here, buying protection in the form of puts makes the most sense (unless exiting makes you feel better).  As an aside:  DO NOT refuse to exit this trade to avoid locking in a loss.  If this position no longer feels right to hold, then please don't hold it.  On the other hand, if you like the adjusted trade and want it as part of your portfolio, then adjusting is the better choice.

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