Skill Sheet: What You Will Learn Here
- When do you need an adjustment?
- Adjustments to manage a profitable trade
- Adjustments to manage a losing trade
- When are adjustments not needed?
When one trades in the cash market or in futures, there are limited options available after initiating a trade.
Suppose a trader buys a share at Rs 150 and it goes up to Rs 170, the profit can be booked – partially or wholly – or more shares ca be bought if the run-up has just started. This way, more capital is committed to the trade to generate extra profit.
If the share price falls, a loss can be booked or the trade can be averaged out by buying more shares. This is known as the Martingale Strategy, where additions are made to the position and the average cost is brought down in the hope that the share price will eventually recover. Here, too, there is little that one can do to remedy the trade without additional capital.
Thankfully, options trading provides the legroom to remedy a trade that has performed against expectations or to milk the trade for the duration of its move.
Even when an options trade works favourably or unfavourably, there are ways to adjust positions to save on the trade or extract as much as possible out of it, without too much additional cost.
To put it differently, the risk-reward matrix of an options trade can be altered by making adjustments to fit one’s comfort zone. However, adjusting trades does not guarantee that it will be a winner.
Just like creating an options strategy, adjusting an existing strategy requires good knowledge of options trading.
When an adjustment is needed
There are two times when an adjustment will be needed. One is when the trader has milked enough juice out of the existing trade and the other when positions needs to be shifted to align with the trend.
Adjustments to manage a profit trade
Suppose, a trader has created a Bull Put Credit Spread by selling a 17,500 put option and buying a 17,550 put of the same expiry. The trade would have been created with a spread of say, 23 points.
In this case, the trader will benefit if the market rises. The maximum profit will be equivalent to the premium collected, which will happen when the market crosses 17,550. Even if the market goes beyond 17,550, the trader will only earn 23 points.
At this point, there is little reward left on the table and the risk-reward is skewed in favour of either closing the trade or taking a new position.
If, after the strong move, the trader feels the market can continue higher, he will close the existing Bull Put Credit Spread, which would be close to zero (since it is a credit spread the trader will make a profit if the spread falls). He will then shift his position to a higher spread value, say, by selling the 17,550 PE and buying a 17,600 PE.
The move will help the trader ride the journey by shifting to a risk-defined options strategy.
What the trader has done is called ‘rolling up’ in options terminology. He has rolled his position higher.
Rolling up of trade is when the trader has booked a profit in his position and has rolled over his position in line with the direction of the market.
If the trend is strong and expected to continue to the next expiry, the trader may think of continuing his trade to the next expiry by rolling out his trade. If by rolling out his trade, he also shifts the position to a higher strike price, it will be called a rolling out and rolling up of his position.
Adjustments for a losing trade
Traders will have their share of losing trades even when they trade option selling strategies.
If the trader takes a multi-strike strategy like a Strangle or an Iron Condor, the strategy can be adjusted by booking the profit leg and moving it closer to the market. The time for moving the strategy depends on multiple factors.
Some traders make adjustments using the delta value. Both these strategies are delta-neutral – the net delta value of the strategy is near zero at the time of creation. However, as the market moves, the net delta keeps changing.
Suppose a trader creates a Strangle by selling a 17,300 put and a 17,800 call. The market was at about 17,500 when the strategy was created and had a net delta value near zero.
If the market starts falling and approaches 17,400, the delta of the put option will increase and that of the call option will decrease. In this case, the net delta would be closer to 20.
Traders normally start adjusting the trade when the net delta touches either +15 or -15.
In this case, the trader would book his 17,800 call position for a profit and move it closer by selling a 17,700 call so that the net delta is again close to zero.
The trader would keep on making such adjustments till the trade turns profitable on account of theta decay or till the selling on the call side coincides with the same strike of the put side – in this case, it would be 17,300.
By selling both the 17,300 call and put after adjustment, the trader would be holding a Straddle position and would be sitting on the profits of the adjustments.
If the market keeps falling after a Straddle is constructed, the trader is left with two choices – either book the loss or roll out the position to the next expiry.
When no adjustment is needed
There are times when no amount of adjustments can save a trade. It is wise to exit from the trade and book a loss at such times. In some instances, when the risk-reward is not favourable to continue with the trade through adjustments, it is better to book the profit collected.
Suppose a stock has moved a long distance and is approaching an important resistance level, it makes little sense to carry forward the position. It would be better to close and reassess the scenario.
In trading, it is advisable to think in terms of risk-reward. If by adjusting a trade, the risk-reward improves, it makes sense to adjust it.
For successful options trading, one needs to be a good planner of trades and a good repair mechanic. One should be able to manage the trade using various ways of adjustments to salvage the situation. Adjustments have helped many traders convert their losing positions into either profitable ones or keep losses manageable.