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

13 Responses to Trader Mindset: The Cost of an Adjustment

  1. Robert D. 06/24/2011 at 7:22 AM #

    Mark,

    I have found that one of the challenges of holding an iron condor is mitigating the effects of rising I.V., especially as the underlying approaches the strike of the short put. What do you think about buying a put calendar spread near that strike as a way of alleviating this problem?

    Thanks much,
    Robert D.

    • Mark D Wolfinger 06/24/2011 at 7:59 AM #

      Robert,

      Asking about options and not pizza?

      Yes. An OTM calendar does a lot of good – MOST OF THE TIME. However, if you get an explosion in IV, the calendar will fail for a two reasons:
      a) Stock moves well beyond strike of calendar
      b) Near term IV becomes much higher than that of your long. You know – when panic hits, traders buy the front month options.

      This is a viable method – but it does come with its owns et of risks.

      Good question.

  2. Wayne 06/24/2011 at 9:33 AM #

    Mark,
    Would you say that, in this type of explosive IV environment, a diagonal spread is a good idea? But looking at a risk graph, I see that time is really working against a the diagonal, right?
    Wayne

    • Mark D Wolfinger 06/24/2011 at 10:39 AM #

      Wayne,

      Just so that there is no misunderstanding, we are NOT in an explosive volatility environment at this time. Think of mid to late 2008 as such an environment.

      No, the diagonal is even worse than the calendar spread. If the market moves the wrong way, you will lose extra money due to delta. And if the front-month IV explodes, you will lose more from front-month vega (because IV shot up by far more than the IV of your long option) that you gain from having a position that is positive vega.

      However, that spread (and the calendar) work when IV increases – but not explosively.

      Look at a chart: Open a diagonal or calendar. Raise front-month IV by 60% and raise your long option’s IV by 40%

      Being long vega is good MOST of the time when IV increases. It’s just not good when IV explodes (unless there is very little time remaining before the front-month options that you are short. expire.

      Wayne: If you want black swan protection, long vega is not it. Long one simple naked put will do a very nice job. If you seek protection against a steadily rising IV, then YES, that’s when the calendar or diagonal will be helpful.

  3. rluser 06/24/2011 at 11:32 AM #

    This is the most succinctly I have seen this argument put. Great job.

    • Mark D Wolfinger 06/24/2011 at 5:35 PM #

      Thanks.
      Much appreciated

  4. Ed 06/24/2011 at 5:27 PM #

    On the Trader Mindset…Mark, one of things I appreciate about you is how you bring this kind of perspective again and again (b/c it’s difficult to break the more common psychology of being held hostage by either the original trade or the stock or wanting to get it back).

    I have a slight variation after thinking again on your example, that helps me clarify the decision tree. Let me know if you think it’s aligned with your thinking. If one ignores the original trade completely, then I see the example as follows:
    1) you own an IC position where the risk is uncomfortably high for you today
    2) you are looking at 2 options from the present to future
    a) you can spend $400 and reduce the risk to zero (exit the position completely)
    b) you can adjust the position by spending $550 and reduce the risk significantly with a chance to earn some money on the new position. That new position may only have a current value of $300, so would have to be evaluated on its own.

    In looking at (a) vs (b), clearly (a) has a nice advantage of having zero risk and being simple. It also makes sense that in (b), if I don’t believe I am able to make $150 profit on the new position or if the risk of the new position is too high for that profit goal, then (b) is not better than (a).

    In the above, whatever premium that was obtained for the original IC is not highlighted (though is implicit in the (b) #s)…for me that helps focus on the positions in present and future.

    • Mark D Wolfinger 06/24/2011 at 5:45 PM #

      Ed,
      So many things feel ‘obvious’ that alternatives re never considered. Thanks.

      I agree with every word except for that ‘$150.’

      If you did not have a position to adjust, would trade b) be worth owning? There may be better, safer trades that are just as capable of earning that same projected profit ($150) over the same time span. So, from my perspective, I want this trade to be good enough to own on its own. [Profit is plenty for risk involved] I don’t see why it should be related to the cost of exiting the original trade. If there are better trades that I can find than I’;d rather exit and open the new position.

      Now that is really nitpicking becasue I get what you are saying. We are on the same wave length

      Thanks for sharing.

  5. Ed Hwong 06/28/2011 at 4:03 PM #

    Mark, thanks, your replies are always stimulating. In this case the “$150” number wasn’t supposed to relate to the original loss upon exit (though the same). It was the difference b/t the costs of option (a) and (b). I was thinking this: say I have $550 in my pocket and looking at (a) and (b). (a) makes me feel real good (no risk) and I have $150 left. (b) costs $550, leaving me zero in the bank, and say a position w/ max profit of $300. But I compare this against (a), and so I want to have some “reasonable” chance of ending up with more than (a) i.e. $150…so I would compare the risk of position (b), its profit potential…b/c if I felt that I could only make $100 in (b), then it seems to me that I should just take (a) and find a better trade.

    Trying to understand our own trading psychology wrt adjustments, gains, losses reminds me of a friend who relayed a scenario from a TED talk:

    Gain scenario: you give someone $1000 and then give them a choice:
    They can be conservative and gain a guaranteed extra $500 (for a total of $1500)
    The can gamble and flip a coin to determine whether they get nothing additional or an extra $1000. (for a total of $1000 or $2000)

    Loss scenario: you give someone $2000 and them given them a choice:
    The can be conservative and lose a guaranteed $500 (for a total of $1500)
    The can gamble and lose $0 to $1000 (for a total of $1000 or $2000)

    “It turns out that even though the end results of gambling or being conservative in both scenarios are exactly the same, most people will choose to gamble when they have the potential to gain money and most people be conservative when they have the potential to lose money.”

    I venture that there’s a parallel when people think about playing with so-called “free” money when they have an unrealized gain.

    • Mark D Wolfinger 06/28/2011 at 5:34 PM #

      Ed,

      a) Gives you no risk, no reward, and you have some of your cash left.
      b) Gives you a new (adjusted position can be considered as new – at least to me) position, with no cash left.

      In this case – what is different? What difference does it matter how much profit potential there is in b)?

      Any time you make a new trade b) or any other trade, the profit potential matters. Compare that potential with risk etc and make a decision. But here you want that decision to be based on the cost of the trade for one reason only. Because you are closing another trade first. If you were not doing that, if you were just making a new trade and by coincidence it turns out to be that original trade, adjusted – then would you require that $150 minimum profit?

      This may be a discussion over nothing. I am not certain. But I will tell you this – you can think about profit potential any way that suits. Here I believe you are considering factors that do not matter (to me).

      If I make a trade and pay a debit, and if I earn a profit, then I collect a credit – larger than the original debit. So – I ask: Why isn’t earning $100 sufficient? Why does the fact that b) costs more than a) make any difference to you? I truly believe this is semantics. We can continue forever (feel free to do so) and not get anywhere.

      However I sense the frustration in your post. I am sorry to contribute to that. My goal is to clarify

      “It turns out that even though the end results of gambling or being conservative in both scenarios are exactly the same, most people will choose to gamble when they have the potential to gain money and most people be conservative when they have the potential to lose money.”

      I believe this is backwards. They gamble to AVOID losing. Anything but a loss. That’s what kills traders.
      The same people refuse to gamble when they can LOCK IN the gain. ‘Free money.’ When they have the money in hand, that’s when they play it safe. That’s when they manage risk.

  6. L. Swystun 08/26/2011 at 12:38 PM #

    Mark,

    Just happened on to your website today and must say it is very well written and highly understandable.

    In the example outlined in this topic are you speaking of rolling out when the position has gone
    negative or are you advising to get out of the current position and look for a more promising one?

    Are you actively running the premium site at this time?

    Thanks-Linda

    • Mark D Wolfinger 08/26/2011 at 12:53 PM #

      Hello Linda,

      Thanks.

      No specific ‘adjustment was mentioned.’ Thus, yes, rolling out is one of the possible adjustments. But that is not the only possible adjustment.

      The point of this simple discussion is that traders often allow the cost of the trade to be the only factor worth considering. What you get for your money (in other words, how good is the adjusted position) is of far more importance.

      Yes, the premium site is running: http://www.mdwoptions.com/Premium/home-page/

  7. mark 02/22/2012 at 11:39 AM #

    Hi Mark
    A bit off subject from psychology but talking about adjustments. I bought a SPY mar 136c to adjust my short SPXPM mar 1385/1395 call vertical. It cut my delta in half and gave me some positive gamma. I liked it initially but now the market is dropping a bit it’s quickly losing value. I reviewed my trade and see that either buying 3 SPY mar 136/138 call vertical or buying a SPY ap 137 call would have held up better Can you comment on these strategies
    Thnaks
    Mark