Adjusting 101: How to Adjust an Options Leg
Options trading is not a very cut-and-dry scenario. It requires constant monitoring, risk/reward calculating and at times, adjusting. To adjust an options position, sometimes we need to add a leg to our position. In other scenarios it means we need to “roll” the position. Finally, there are times where we simply need to adjust an options leg.
So what exactly does that mean, to adjust an options leg?
There are actually several variations to this adjustment. In its most basic sense though, it involves selling one leg and adding another without completely altering the foundation of the trade. For instance, say we are long a $100-$105 bull call spread, but would like to expand the spread to allow for more upside potential. We would close the $105 call (buy to close) and open a new leg in the $110 call (sell to open).
In effect, we would adjust from the $100-$105 call spread to a $100-$110 call spread by adjusting just one options leg of the trade.
How to Adjust an Options Leg
In our first “Adjusting 101” series, we talked about why investors may want to consider adding an options leg to their position that’s showing a profit. In some cases, this can remove the risk of the initial capital outlay without severely altering the trade’s reward. Lowering our risk without significantly denting our reward is generally a good position to put ourselves in.
So how can we do that by adjusting our options legs? Let’s look at an example.
Say we are bullish on ABC and plan to take advantage by selling a bull put spread. ABC is trading at $75, so we sell the $73-$70 put spread expiring in 30 days. However, the next day, ABC issues good news and the stock suddenly jolts higher. Now trading at $78, our put spread has lost most of its value. Remember, that’s good news for us since we are short the spread.
In this case, we could consider closing the $73 put and opening the $76 put. We would do this while maintaining our long put position in the $70 strike. Essentially, we are adjusting our position from the $73-$70 bull put spread to a $76-$70 bull put spread.
Is adjusting our only option? Of course not. We could have either held the position until expiration or we could have closed it early for a profit. At times, that will be the most logical move. But in this case, because we got such a dramatic bounce in the underlying stock combined with the move happening so soon after initiating the position, adjusting the option leg could have obvious benefits. The most obvious is, collecting more premium. By closing our initial leg, we realized most of its profit potential and by opening a new one, can realize even more.
Let’s Get Defensive
In our last example, we saw how a trader could adjust his position to extract more premium out of a short spread. The best kind of adjusting comes when we’re maximizing our profit. However, it’s not much fun to have to make adjustments on losing positions.
Unfortunately, part of trading is managing the losers. But luckily, there are maneuvers we can make where we can limit our losses, improve our risk-reward scenario or even reverse our losses.
Say we are long one $55 call option on XYZ, a stock that’s trading at $56 before suddenly sinking to $52. Perhaps some after-hours news negatively impacted the stock. Despite the news though, we expect the selling pressure to be short-lived and we still feel the prospects for a bounce are bright. In this case, we could consider selling two of the $55 calls and buying the $52.50 call option.
Wait, what did we just do? Let’s break it down.
We sold two of the $55 calls. The first brought us back to flat — meaning we had no call opotions left — while the second one brought us to a short position in the $55 call. By purchasing the $52.50 call though, we are now long the $52.50-$55 bull call spread. It should be noted that a move like this doesn’t always work in our favor.
However, there are times where it can be done for either a slight debit or perhaps no cost at all. Meaning that, this adjustment could be free. Now, instead of holding a $55 call, we have a call spread that’s more likely to close in-the-money. Rather than hoping XYZ can recover its recent losses plus return our initial debit that we paid, we only need XYZ to recover to $55 by expiration. Not only will this get us out of the hole, but it will actually bring the trade to maximum profit.
Let’s put some numbers with it to see how it works.
We initially bought the $55 call on XYZ for a $1.00 debit. We need XYZ to close at $56 by expiration to break-even on the trade. However, when XYZ tumbled to $52, our call option’s value decreased to just $0.35. Sitting on a 65% loss, we felt it was time to adjust.
So we sold the $55 call (twice) for a net credit of $0.70, while paying $0.80 for the long $52.50 call option. Excluding commissions, this trade has a net debit of $0.10. While the adjustment was only $0.10, remember that we initially paid $1.00 for the $55 call. So our break-even (again, excluding commissions) is $53.60.
Now instead of needing XYZ to rebound to $56, we only need it to bounce to $53.60 to recover our cost. Should shares close at or above $55, we’ll realize our maximum profit of $1.40 — ($2.50 spread value – $1.10 net debit = $1.40 in profit).
Admittedly, at times it’s best to cut the losses and move on. At other times though, it pays to get creative and adjust an options leg.