Adjusting 101: When to and Not to Adjust an Options Position
Over the last few weeks, we have been delving into the adjustment portion of trade management. Whether an options trade is working for or against you, there are times where it’s prudent to adjust the position. Put simply, the risk/reward dynamics shift and when that occurs, it may be best to counter by adjusting the trade. It’s both a blessing and a curse for options traders to be able to do this.
In one sense, it’s a pain because we now need to decide if adjusting is what’s best for our portfolio. If we decide that adjusting is the best move, we then have to decide what adjustment to make. On the flip side, options traders can get a chance to reverse their bad fortunes (or enhance their good fortunes) by adjusting.
Over the past few weeks, we’ve covered a number of key adjustment strategies. There’s rolling an options position, which involves adjusting the expiration date, strike price or both. We’ve also talked about adding legs to the trade as well as how to adjust just one leg of a spread.
When to Adjust an Options Position
When is the best time to adjust? We want to adjust our options position when it meaningfully improves our risk/reward. However, we can’t adjust our position just for the sake of adjusting. It doesn’t take much for the market to turn against us and if we over-adjust, we could easily be caught out of position. Further, too much adjusting will eat away at our profit margin thanks to commissions. At many brokers, trading spreads is a more expensive endeavor and so continual adjustments can sap the gains of even the best strategies.
With that in mind though, let’s consider some scenarios where it makes sense to adjust. We can make adjustments as an offensive or defensive move. Let’s start with the former.
If we’re bullish on ABC, we can play a few ways, such as through calls or bull call spreads. If ABC goes on a strong rally, our calls or call spreads can appreciate considerably — sometimes by several hundred percent. While the gains are quite welcome, the position can become too large for our trade-size preferences. Further, the risk/reward can shift away from having a low-risk/high-reward setup, to having a higher-risk/limited-reward setup. In that case, we may want to consider rolling the trade higher. This would mean we sell our calls or call spreads and simultaneously buy calls or call spreads with a higher strike price. This is called “rolling up.”
If we believe the bullish trend in ABC can continue, we can buy calls or call spreads with more time until expiration. This is called “rolling out.” And for those that want to increase the strike price and extend the expiration date, this is called “rolling up and out.”
Adjusting on Defense
Unfortunately, we won’t win 100% of the trades we enter. But sometimes there are ways to limit our losses and at times even erase them by adjusting. In the last example we were using a debit spread adjustment. In this scenario though, let’s use a credit trade.
Say we are bearish on XYZ, which is now at $55. It’s been rallying too far, too fast. In an effort to capitalize on this over-exuberance, we sell some $57.50/$60 bear call spreads for $0.40 expiring in 21 days. Unfortunately, the stock grinds higher and ultimately pops over our short calls. It’s now trading at $58 with just a few days left to go.
We can wait until expiration and hope the stock comes back down. However, we still believe in our thesis that XYZ is overbought. Instead, we roll the trade out — closing our $57.50/$60 bear call spread and buying the same spread with another 30 days until expiration.
We had to close our original trade at $0.60 — a $0.20 loss — but by choosing a contract with a later expiration date, we were able to collect $0.75. Remember, XYZ can continue to rally, causing our pre-rollover losses to worsen. However, if we are correct and XYZ suffers a pullback, we could realize the full profit of the current trade.
While we could realize $0.75 in profit on this trade, remember we rolled over from the first trade with a $0.20 loss. That should be calculated into the trade too. If all goes to plan, we could have a $0.55 gain (excluding commissions) rather than a $0.20 loss, all thanks to adjusting.
When Not to Adjust
As great as adjusting can be in some cases, there are other times where it’s simply best to exit the trade. Just like adjusting, this goes for playing both offense and defense.
Take the first example with ABC. We are bullish and nail a well-timed trade in the name. We bought call spreads on the name and had a $50 target for the underlying security when it was trading for $45. With shares at $49, there’s limited upside left in the name. In this case, it doesn’t make sense to roll the options up or roll them out.
Why? Because if we don’t believe in more upside, there’s no reason to buy higher-strike calls. Further, the stock is already near our target and that leaves us with little reason to extend the expiration date. In this case, it’s best to take our chips off the table and find another trade.
In trading, we always need to think about the potential loss rather than the possible reward. That’s never more true than when playing defense. Say we buy a $30 call position in BCD, but shares suddenly decline. Sometimes, investors can adjust the position, selling 2 $30 call options (to get a net position of short 1 $30 call option) and buying a lower-strike call to create a bull call spread.
At times, this can be done for little or no debit at all and allows us a chance to play for a rebound and still turn a profit. Here’s one example.
However, if the cost of this adjustment is too high or the maximum reward isn’t enough to salvage the trade, then it may make more sense to simply close with a loss. Why? Because we can’t save all trades, be it from a risk/reward standpoint or a total shift in the trade thesis. Either way though, know that sometimes it’s best to just close the trade. Be it taking our profits off the table or ending the pain by cutting our losses. We figure this out on a trade-by-trade basis. But don’t let the fear of loss or the greed of profit drive your decision making. It needs to be an attractive risk/reward setup to adjust the trade.