If you trade options longer than ten days you’ll undoubtedly run into a scenario where you get challenged by a stock moving either higher or lower against your position. When this happens the first question many people ask is “Do I start rolling up strike prices and adjust the position or work on closing out the trade completely at a loss?” Naturally, we are in the camp where we believe, and our backtesting confirms, that rolling your strike prices closer to where the stock is trading and taking in additional net credits ultimately gives you the best opportunity to either profit or reduce risk on the position. On today’s podcast we’ll explore this topic more deeply with a very detailed example and walk through so you understand conceptually how it all works moving forward.
Key Points from Today’s Show:
- When you roll up your strike prices, you are collecting more credits.
- This moves the unchallenged or untested side of the trade closer to where the market is.
- Taking what the market gives you and adjusting along with the markets as they move.
If the stock is trading for $100 and starts to run up to $105, you would roll up your puts, which are below the market. If the stock is trading at $100 and starts falling to $95, roll down the calls closer to where the stock is trading.
Why Adjust Instead of Closing Out?
- When adjusting a position without adding any additional risk, you take in more credit.
- The credit widens your break-even point on your challenged side.
- If those break-even points are ever breached, then at least you have effectively reduced risk.
- An adjustment reduces the loss that you might have on that particular side of the trade.
- This cuts the trades loss profile, creating an unintentional win.
*Myth: the trade you start with is the exact same trade you end with.
That is only true if you never make an adjustment.
Example: If you start with a strangle, that doesn’t mean you end with a strangle. You could potentially adjust the trade into straddle. So if you have a trade with a 70% potential chance of success to start with and the potential to lose $500, the goal is not to lose the maximum amount. It’s always to adjust into a position to cut the loss. This is another way to break the zero-sum cycle.
A stock is trading at $100. You sell the 95 puts and the 105 calls to create a simple strangle position. Next, you sell the strangle for a $2 credit, so you collect $200 of premium. This moves the break-even points on either end to 93 on the put side and 107 on the call side.
Next, the stock starts to rally higher, all the way up to 104. If you are still 2 or 3 weeks until expiration, roll up the short 95 put options to the $100 strike price where it was originally trading. The only side of the trade that is generating money is the put side. Say those puts now have decayed in value to $20, or 20 cents of the option premium. They have gone down in value because the stock has run up, which is ideally what you want when selling naked puts.
Then, you want to close out of the put options, roll them higher to the $100 strike because the $100 strike is going to carry more premium than the 95 puts. It’s much closer to the stock, has a higher chance of going in the money, therefore it has more premium. By rolling up, you are closing out the 95 puts, buying them back for 20 cents, and then resell another put option at the $100 strike. This transfers the position from one strike to another.
Now, you can sell the $100 strike put options for 80 cents. You can no longer sell them for the original dollar and you are closer to expiration. The net credit that you collect in this case is 60 cents between the buy and the sell. This is considered an additional net credit to your original position.
At this point, you have the 100 strike puts and the 105 strike calls and the stock is trading at $104. This time the credit you have taken in is a total of $2.60. This moves the break-even point on the call side from 107 up to 107.60. By rolling up the put side and adding the additional credit you are now moving the range on your call side break-even up by the amount of credit taken in. The credits may allow you just enough wiggle room to be profitable in the position, which is the main goal.
Now, the stock is trading at $104, you are still leaving room for the stock to come back down. Adjustments get more and more aggressive as you start getting close to expiration. Three weeks out from expiration, you want to make an adjustment but still, leave room for the stock to come back down. If the market does challenge you, make an adjustment but leave room for the market to ebb and flow.
The market continues to move aggressively against your position. From the 104 strike, it moves up to the 107 strike. Now it’s right on the doorstep of your break-even point. A week out from expiration, you are now at a break-even point. But because you rolled up your original puts from 95 to 100, you still have 60 cents of room for the stock to move and still make money on the position. The profit will not be a lot, but there is still room for the position to generate some income.
At this point, you can start to be more aggressive by rolling up your put options even further. The options on the call side are in the money, not yet at risk of assignment on those contracts. Now you can buy back your strike put options for 20 cents. Can also sell the 105 calls for 60 cents. You are now able to sell for less and less credit as you get closer to expiration. Rolling up from the 100’s to the 105 puts will give you a net credit of 40 cents.
This net credit gets added to overall premium and credits collected, for a total of $3 in overall credit, moving break-even point $3 from call strike price, adjusting the break-even point out to 108. Now you have the straddle at 105 for the month of expiration. This leaves another $1 that the stock can move before we actually truly start losing money after all the credits that you received.
- Adjusting the unchallenged side of a trade allows you to move the break-even point.
- When the break-even point is wider, it gives you more room to potentially make a profit on a losing trade.
- Making an adjustment allows you to collect more premium, increasing net overall credit.
- As you get closer to expiration, be more aggressive with your adjustments still leaving room for the market to move.
Free Options Trading Courses:
- Options Basics [20 Videos]: Whether you’re a completely new trader or an experienced trader, you’ll still need to master the basics. The goal of this section is to help lay the groundwork for your education with some simple, yet important lessons surrounding options.
- Finding & Placing Trades [26 Videos]: Successful options trading is 100% dependent on your ability to find and enter trades that give you an “edge” in the market. This module helps teach you how to scan properly for and select the best strategies to execute smarter option trades each day.
- Pricing & Volatility [12 Videos]: This module includes lessons on mastering implied volatility and premium pricing for specific strategies. We’ll also look at IV relativeness and percentiles which help you determine the best strategy to use for each and every possible market setup.
- Neutral Options Strategies [7 Videos]: The beauty of options is that you can trade the market within a neutral range either up or down. You’ll learn to love sideways and range bound markets because of the opportunity to build non-directional strategies that profit if the stock goes up, down or nowhere at all.
- Bullish Options Strategies [12 Videos]: Naturally everyone wants to make money when the market is heading higher. In this module, we’ll show you how to create specific strategies that profit from up trending markets including low IV strategies like calendars, diagonals, covered calls and direction debit spreads.
- Options Expiration & Assignment [11 Videos]: Our goal is to make sure you understand the logistics of how each process works and the parties involved. If you don’t feel confident in the expiration processes or have questions that you just can’t seem to get answered, then this section will help you.
- Portfolio Management [16 Videos]: When I say “portfolio management” some people automatically assume you need a Masters from MIT to understand the concept and strategies – that is NOT the case. And in this module, you’ll see why managing your risk trading options is actually quite simple.
- Trade Adjustments/Hedges [15 Videos]: In this popular module, we’ll give you concrete examples of how you can hedge different options strategies to both reduce potential losses and give yourself an opportunity to profit if things turn around. Plus, we’ll help you create an alert system to save time and make it more automatic.
- Professional Trading [14 Videos]: Honestly, this module isn’t just for professional traders; it’s for anyone who wants to have eventually options replace some (or all) of their monthly income. Because the reality is that mindset is everything if you truly want to earn a living trading options.
Option Trader Q&A w/ Daniel
Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today’s question comes from Daniel, who asks:
I have a question regarding the VXX. I’ve heard you mention in the past that if VXX were to spike or volatility were to spike you would sell calls at the money several months out and let that implied volatility drift lower and let that time decay work. Would you ever do the opposite? If you thought the market was in for a correction, or your indicators indicated that, would you ever sell puts on VXX and make a put spread or something like that and do the same thing?
Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.
PDF Guides & Checklists:
- The Ultimate Options Strategy Guide [90 Pages]: Our most popular PDF workbook with detailed options strategy pages categorized by market direction. Read the whole guide in less than 15 mins and have it forever to reference.
- Earnings Trading Guide [33 Pages]: The ultimate guide to earnings trades including the top things to look for when playing these one-day volatility events, expected move calculations, best strategies to use, adjustments, etc.
- Implied Volatility (IV) Percentile Rank [3 Pages]: A cool, simple visual tool to help you understand how we should be trading based on the current IV rank of any particular stock and the best strategies for each blocked section of IV.
- Guide to Trade Size & Allocation [8 Pages]: Helping you figure out exactly how to calculate new position size as well as how much you should be allocating to your each position based on your overall portfolio balance.
- When to Exit/Manage Trades [7 Pages]: Broken down by option strategy we’ll give you concrete guidelines on the best exit points and prices for each trade type to maximize your win rate and profits long-term.
- 7-Step Trade Entry Checklist [10 Pages]: Our top 7 things you should be double-checking before you enter your next trading. This quick checklist will help keep you out of harms way by making sure you make smarter entries.
Real-Money, LIVE Trading:
- EWZ Iron Butterfly (Closing Trade): After nearly pinning the stock at our short strikes, and thanks to the volatility drop, we netted a $600 profit on this iron butterfly trade.
- VXX Short Call (Closing Trade): One of the most consistent and profitable options trades we can make is shorting pure volatility with VXX and today we closed this naked short call in VXX after a couple days for a $420 profit.
- DIA Iron Condor (Adjusting Trade): This neutral iron condor in DIA is need of a quick adjustment early this week as the market continues to rally. In this video, we’ll discuss why I’m adding an additional put credit spread while also choosing NOT to close out of our current put credit spread due to pricing reasons.
- COP Short Put (Closing Trade): These single short puts in COP acted as a great hedge for our other bearish bets in oil this month and helped smooth out our returns after we closed them for a nice big profit.
- TSLA Put Debit Spread (Closing Trade): Although many people thought we were crazy for getting bearish in TSLA this pre-earnings put debit spread trade made us $200 today. After the huge run up from $140 to $260 and getting some technical sell signals, we were pretty sure this stock would pull back.
- MON Iron Condor (Closing Trade): Following a huge drop in implied volatility we worked hard to close this MON iron condor trade adjusting the order multiple times to fill before the end of the day.
- IBB Call Debit Spread (Opening Trade): We’ll show you how I started searching for a new bullish trade and eventually found a low volatility trade in IBB looking for a move higher to hedge our portfolio.
- TLT Iron Butterfly (Closing Trade): Following the Brexit vote TLT and bonds traded in a nearly $8 range really quickly – even still the drop in implied volatility helped generate a $330 profit for us.
- XBI Call Debit Spread (Closing Trade): Got lucky picking the exact bottom for our entry in this call debit spread for the XBI biotech ETF which ultimately was closed for a profit of $165 today on the rally higher.
- COH Iron Butterfly (Earnings Trade): Shortly after the market open we close out of our COH earnings trade for about a $160 profit, leaving just 1 leg on to expire worthless.
- EWW Debit Spread (Closing Trade): Using some of the technical analysis signals we discovered in our backtesting research, we were able to make a quick $130 profit on this bearish EWW debit spread trade.
- IBM Iron Condor (Earnings Trade): Shortly after the market opened you’ll follow along with me as we watch volatility drop and liquidity come into the market before closing out the position for $250 profit.
- SLV Short Straddle (Opening Trade): Using our watch list software we decided to continue to add to our existing SLV short straddle position with a new set of strike prices reflective of the move lower in the ETF recently.
Thank You for Listening!
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