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.

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11 Responses to Trader Mindset Series: IV. Adjust or Exit?

  1. Darren 06/16/2011 at 6:31 AM #

    On my monthly positions I always have 2-3 technical levels that I use as “assessment points” and if needed, adjust my position. There is definitely an art to it and I do my best to sell far enough out-of-the-money to avoid adjustments. However, it seems that there are at least 1-2 times per year that it’s required.Your reference to a “comfort zone” for risk/reward is spot on.

    • Mark D Wolfinger 06/16/2011 at 6:38 AM #

      Darren,

      If you never have to adjust, then you are too far OTM.
      Once or twice per year sounds very comfortable, but I confess that I adjust more frequently

      Regards

      • Don 06/16/2011 at 6:43 AM #

        Hi Mark, how many times a year do you find that you have to adjust- it’s actually a good idea to see how often to assist in setting up trades that fit a comfort zone.

        • Mark D Wolfinger 06/16/2011 at 7:02 AM #

          Don,
          I don’t have any records of that.
          This year, only once month (current positions).

          But I trade 15+ delta iron condors, and that means one option finishes ITM about 1/3 of the time. So that’s at least four times, on average. However, I don’t wait that long to adjust (I am not happy being short near ATM options) and would say that I adjust 6 times per year, on average.

          Statistics tell you what to expect. Get the probability of ‘touching’ and you will have a bare minimum number. Calculate the probability of reaching your point (X points OTM) and you get a much clearer picture.

  2. Thomas 06/16/2011 at 8:16 AM #

    Hi Mark,

    What do you mean when you say adjust. I read some time ago in yur blog that the way you proceeded with the kind of condors you did was closing both spreads if 30 days remaining for 1$ or closing the threatened spread close to get ITM. Your expected gain was because you only had a 1 of 3 debt IC. If you say youn adjust 1 of every two statistacal gain sould be negative.

    May be your trading style has changed because low volaitlity as I apreciate ┬┤cause I can see you use higer deltas, but that means your are not using long time IC now.

    thanks

    • Mark D Wolfinger 06/16/2011 at 8:36 AM #

      Thomas,
      I still trade 13-week iron condors.

      When I use the term ‘adjust’ I mean making a change to the original position.
      Sometimes that means reducing size by closing a portion of the trade. Sometimes it means closing the whole trade. But most of the time ‘adjust’ means to make a new trade that reduces the risk of owning the original position. For example, if the market is rising, I add a trade that earns money on a further rally.

      The idea is to offset a portion of future losses – if the market continues to move in the ‘wrong’ direction. This does not eliminate all risk. But it does reduce risk by enough so that I still want to own the newly adjusted position.

      Adjustments do not always result in losses. Sometimes the adjustment leads to additional gains or allows me to earn some profit from the original trade, even if it less than I had hoped to earn.

      Even if adjusting one-half of my trades, that does not suggest that money is being lost.

      Hope that answers your question.

      Regards

  3. Dimitrios 06/16/2011 at 10:32 AM #

    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

    • Mark D Wolfinger 06/16/2011 at 11:52 AM #

      Dimitrious,

      Good question.
      See tomorrow morning’s post for my reply.

      Thanks

  4. Mike 06/16/2011 at 6:53 PM #

    I own some stock and wish to sell covered calls, one unit. I also do not care if the stock sells as I make money on the sale anyway, plus the premium.
    The July expiration on my strike price of 60.00 is 1.00 thus I receive a premium of 100.00 (minus commission).
    The Sept expiration of my strike price of 60.00 is 3.00 thus if I went with the Sept expiration, I would receive 300.00 premium for the one unit (minus commission).

    My question is: Since I am trading in the USA and not Europe, and can buy to close at any time, would not my purchase of the Sept (or perhaps December)contract make better sense?
    I have tried this 3 times and it seemed I did very well when I bought to close well prior to the expiration .

    Sorry 2nd question……..would not this logic be fine for selling naked puts, as well, as I am happy if I get a larger premium for a further out, selling put contract, and I do not mind purchasing the good stock that I have the put on at the lower price if it comes to that in the longer time span?

    • Mark D Wolfinger 06/17/2011 at 8:19 AM #

      Hi Mike,

      Good questions.

      Glad you are willing to be assigned an exercise notice. That makes covered call trading far more efficient.

      Where you live (or where the options trade) has nothing to do with whether options are American style or European style options. For the record – both styles of options can be bought to close at any time. The difference is that European style options cannot be exercised earlier than expiration.

      I assume you are referring to the ‘sale’ of Sept options, rather than the purchase. Writing (selling) Sep options makes more sense from this perspective: You collect more premium, giving you better protection if the stock declines. However, many traders prefer to sell the near-term (Jul in this example) because they earn more money (when the stock does not decline) on an annual basis. Your example is different. The Sep option offers a higher annualized return, and that would be my choice.

      Neither is ‘right’ and neither is ‘wrong.’ ‘Makes more sense’ is really based on which each individual trader feels comfortable trading. I also like the idea that you covered before expiration – presumable to sell a new call with a longer lifetime.

      December is too far out in time for me. However, if you lack time to spend on trading, it may make sense. But not otherwise.

      Yes, the same thought process applies to writing naked puts.

      Thanks for the questions.

      • Mike 06/17/2011 at 8:29 AM #

        Thanks for taking the time to answer. I appreciate it.