Managing Option Trades That Go WRONG
How do you manage an options trade that goes in the wrong direction?
Learn how to use covered calls to reduce the price of buying a call or to hedge for the downside potential of your existing stocks.
Bullish Option | Straddles
How do defend your options trade
Learn how to set up and profit from diagonal calendar spreads
General Principle:
- Always gain more premium if you are looking to defend your trade
- Gaining more premium reduces the cost basis ( gains more credits ) and also improves your break-even point.
- The goal is to decrease your losses; not necessarily to change a losing trade to a winning trade.
Main Strategies for defending an options trade
- Roll the trade
- Roll out in time
- Increase spread width will increase premium but also risk
- Moving the trade closer to in the money will gain more premium
Closing Trades
Through our research, we have found an optimal closing point for trades based on historical data. We analyzed closing our trade at a multiple of the premium collected for premium selling trades. For example, if we collect $1.00 for selling an option, we analyzed the overall P/L based on closing the trade at 1x loss, 2x loss, 3x loss, etc.
We found that closing our trade for a net loss of 2x credit received can be optimal.
This means that if we collect $1.00, we would close the trade when the value of the option reached $3.00. This would be a $2.00 net loss. We found that this closing point gives us wiggle room for the trade to revert back to profitability, but also protects us from further losses.
Rolling Trades
The main objective with rolling a trade is to keep the dream alive, but we don’t pay for this dream. We roll trades forward in time for a credit. It’s important to remember that when rolling a trade, we are locking in a losing trade, and opening up a new low probability trade. If we sell an OTM option to open, a defensive roll is almost always ITM, which means that if we keep the same strike and roll the option forward in time we are opening a short option ITM. This is a lower than 50% POP trade. For that reason, we always ensure that we collect a credit so that we improve our breakeven & cost basis. If we pay for the roll we actually hurt our breakeven & cost basis while opening a low probability trade!
We can adjust our strikes, but we still want to do this for a credit. Usually with naked options this means that we have to roll even further out in time if we want to move the strike closer to the stock price to improve our probability of the option expiring OTM.
The best case scenario for a rolled trade in a short premium play is when the option moves from being ITM to OTM. At expiration this will result in erasing our previous losses, and realizing a profit from the credit we’ve received from the initial trade & roll.
We usually roll our trades 7-21 days prior to expiration to avoid gamma risk & assignment risk that grows as expiration nears.
The first profit target is generally 25% of the maximum profit. This is done by buying the straddle back for 75% of the credit received at order entry.
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Option Basics
Principles
General:
- Never sacrifice on single trade for the sake of the overall portfolio. Sometimes you have to let a trade go unadjusted because adjusting it would be detrimental to the profitability of all the other positions.
- Always take in a net credit when making adjustments
- Taking in a net credit will widen the break-even points and increase the probability of success, reduces maximum risk, and increases the probability of success.
- Account Size Importance
- Larger accounts have a lot of luxuries that smaller accounts do not. For example, if a trade goes against us in a large account, we could hold the losing trade and roll it into perpetuity and hope that eventually the trade goes our way and we can get out for a net profit. It’s harder to do this in a smaller account, as losing trades can eat up a larger amount of the portfolio. It’s much easier to keep our individual trade risk small relative to our portfolio in a large account compared to a small account. If we have a losing trade in a small or large account, we have a decision to make. We have to decide whether we want to roll the position forward in time and keep the dream alive, or close the position at a loss to protect the value of the account. When making this decision, we have a few things we consider:
- Debit spreads are direction trades that bet on the stock moving up for call spreads or down for put spreads.
- Call debit spreads are created by buying a call while selling a call at a higher strike price
- Put debit spreads are created by buying a put while selling a put at a lower strike price.
- You will only make an adjustment if the price of the stock has moved completely against you and has moved beyond the long strike.
- You will not make an adjustment if the price of the stock remains between the two strikes as you will have make a partial profit.
Option Basics
Why is one of the core principles of making a trade adjustment to take in a net credit?
Taking in a net credit will:
- Widen the break even points. By taking in a net credit, you your new credit becomes the sum of the old credit PLUS the new credit. This fact may not reflect on your portfolio statement and might have to be documented by hand in your profit and loss statement.
- Reduces the maximum risk of the trade. By taking in a net credit your new maximum risk is the difference between the spread width minus the credit. If the spread width remains the same and the credit is greater, then then your over all risk has decreased.
- Increases the probability of success. By widening the breakeven points, the probability of reaching the breakeven point is increased.
Option Basics
How account size improves your ability to defend an options trade
- Account Size Importance
- Larger accounts have a lot of luxuries that smaller accounts do not. For example, if a trade goes against us in a large account, we could hold the losing trade and roll it into perpetuity and hope that eventually the trade goes our way and we can get out for a net profit. It’s harder to do this in a smaller account, as losing trades can eat up a larger amount of the portfolio. It’s much easier to keep our individual trade risk small relative to our portfolio in a large account compared to a small account. If we have a losing trade in a small or large account, we have a decision to make. We have to decide whether we want to roll the position forward in time and keep the dream alive, or close the position at a loss to protect the value of the account. When making this decision, we have a few things we consider:
- Debit spreads are direction trades that bet on the stock moving up for call spreads or down for put spreads.
- Call debit spreads are created by buying a call while selling a call at a higher strike price
- Put debit spreads are created by buying a put while selling a put at a lower strike price.
- You will only make an adjustment if the price of the stock has moved completely against you and has moved beyond the long strike.
- You will not make an adjustment if the price of the stock remains between the two strikes as you will have make a partial profit.
Option Basics
How do you defend a vertical debit spread?
General:
- Debit spreads are direction trades that bet on the stock moving up for call spreads or down for put spreads.
- Call debit spreads are created by buying a call while selling a call at a higher strike price
- Put debit spreads are created by buying a put while selling a put at a lower strike price.
- You will only make an adjustment if the price of the stock has moved completely against you and has moved beyond the long strike.
- You will not make an adjustment if the price of the stock remains between the two strikes as you will have make a partial profit.
The key principles in defending debit spreads are to:
- Adjust the short option toward the long option *but not beyond the option’s break even point for a credit
- Do nothing
- Create an Iron Condor
Adjusting the short option:
- Always adjust ( roll ) the short option toward the long for a credit
- Gaining credits will reduce the cost basis of the long option
- Never adjust the short option beyond the break even point
Do nothing
- Doing nothing is an option if the loss will be small or if rolling is difficult to obtain a decent credit.
- If you aren’t able to roll for decent credit, you will be accepting a greater risk ( loss ) and paying for it.
- Setting up an iron condor on the other side and centered around the stock price will reduce the cost basis while theoretically creating a winning trade.
Option Basics
How do you defend a Covered Call
General:
- Covered calls are direction trade that in many ways resemble vertical call credit spreads, and are often used to hedge a trader’s stock or portfolio.
- A covered call is created by selling a call above a stock in which you own 100 shares. If you already own 100 shares, then you will simply sell a put above it. If you don’t, you will have to purchase 100 shares.
- The best scenario is if the stock moves in your favor but does not cross the short strike.
- Break even is the long strike minus the credit ( BE is less than the long strike )
The key principles in defending debit spreads are to:
- Adjust the short option toward the long option to gain more credit or to lower the break even point.
If the stock price increases near expiration toward the short strike
- Close the short strike for a profit before it crosses the short strike.
- Notice that you will have made a profit on the long stroke also
- And your break even has improved by the price of the profit on the closing of the short strike
If the stock price increases over the short strike
- You will do nothing
- This is actually a great scenario. The short strike will lose, but the long strike is now in the money.
- You can close and collect your profits followed by rolling the short strike out to the next month for another covered call
- You will roll the short strike down toward the long strike and hopefully collect more premium.
- This will not necessarily avoid a losing trade but will lower your cost basis.
Option Basics
How do you defend a call option?
Key Points
Not every stock you buy will go up or will every bullish or bearish options strategy go the direction you expect.
What should you do when things don’t go as planned?
Find out how to adjust your original long options strategy to potentially recover some or all of your losses, or even turn a losing trade into a winner.
If you are bullish on a stock, you might buy it. Or, you might decide to buy a long call option—giving you the right (but not the obligation) to buy the stock if it reaches the specified price during a specified amount of time—in order to limit your losses in case you’re wrong.
These two strategies are not perfect substitutes for the following reasons:
- Long stock involves ownership whereas an option position does not.
- Small declines in a stock position may eventually be recovered, whereas similar declines could cause an option to become completely worthless.
- Stock positions exist indefinitely in most cases while options always expire.
- Long stock owners have voting rights and can receive dividends if paid whereas option owners do not.
Long call options can also give you leverage that can result in a larger profit (from a percentage standpoint) than purchasing the stock outright. But you generally have to be right about the stock’s direction, the magnitude of the move, and often the time frame.
If you’re wrong about any of these items, the option can lose value and eventually expire worthless, resulting in a total loss. That’s the bad news.
The good news is, just because you bought a long call and the stock price has not increased, it doesn’t mean all hope is lost. It may still be possible to “manage” the position for a slightly modified expectation.
How can you manage your position?
Let’s review some examples. Assume it’s May 31, 2014 and you are bullish on XYZ with its $87.50 current price. Rather than buying 1,000 shares of XYZ, you have decided to make the following trade:
Buy 10 XYZ July 90 calls @ $3.50 (to open)
Net cost = $3,500 (3.50 x 10 x 100)
Days until expiration = 51
Breakeven = $93.50 (strike price + options premium)
Maximum loss = $3,500 (cost of the trade)
Maximum loss occurs at $90 or below, at expiration
Maximum gain = Unlimited
Commissions, taxes and transaction costs are not included in this discussion. Please be aware these costs can affect the final outcome significantly, and should always be considered.
Your original position
Source: Schwab Center for Financial Research.
Now, two weeks later, XYZ has dropped to $85.00 and your calls have fallen to $1.88. As a result, you currently have an unrealized loss of -$1,620. What do you do?
First, reassess your opinion of XYZ and ask yourself the following questions:
- Is my original price target still valid?
- How bullish or bearish am I on this stock? Am I still as bullish as I was? Slightly less bullish? A lot less bullish? Have I turned bearish?
- Can I lower my breakeven price?
- Should I lower my profit expectations?
- Am I willing to spend additional money to adjust this trade?
- Would it be better to just close my position and cut my losses?
There are many possible ways to manage your original position, but your answers to these questions may provide guidance.
A little less bullish than before
If you are still bullish (though a little less so), you might consider converting the original long call position into a bullish call spread by selling some higher strike calls.
Buy 10 XYZ July 90 calls @ $3.50 (to open) ◄original position
Sell 10 XYZ July 95 calls @ .75 (to open)
Net credit = $750 (.75 x 10 x 100)
Days until expiration = 37
Breakeven = $92.75 (original breakeven – new credit) or ($93.50 – $.75)
Maximum loss = $2,750 (net cost of both trades) or (-$3,500 + $750)
Maximum loss occurs at $90 or below at expiration (both options expire worthless)
Maximum gain = $2,250 (difference in strikes – net cost of both trades) or ($5,000 – $2,750)
Maximum gain occurs at $95 or above at expiration (stock is bought at $90 and sold at $95)
Net new position
Source: Schwab Center for Financial Research.
The effect of turning your long call position into this bull call spread is by forgoing any additional profit potential above $95, the maximum potential loss is reduced by $750 (to $2,750), the breakeven price is lowered by .75 points (to $92.75), and your unrealized loss is reduced by $750 (to $870).
A lot less bullish than before
If you are still bullish (though a lot less bullish than before), you might consider closing the original long call position, and creating a bullish call spread by reversing the original position and purchasing some calls with lower strike prices.
Buy 10 XYZ July 90 calls @ $3.50 (to open) ◄original position
Sell 10 XYZ July 90 calls @ $1.90 (to close)
Sell 10 XYZ July 90 calls @ $1.90 (to open)
Buy 10 XYZ July 85 calls @ $3.80 (to open)
Net debit/credit = $0 (($1.90 + $1.90 – $3.80) x 10 x 100)
Days until expiration = 37
Breakeven = $88.50 (long strike price + net cost of all trades) or ($85 + $3.50)
Maximum loss = $3,500 (net cost of all trades) or (-$3,500 + $1,900 + $1,900 – $3,800)
Maximum loss occurs at $85 or below at expiration (all options expire worthless)
Maximum gain = $1,500 (difference in strikes – net cost of all trades) or ($5,000 – $3,500)
Maximum gain occurs at $90 or above at expiration (stock is bought at $85 and sold at $90)
Net new position
Source: Schwab Center for Financial Research.
The effect of this new (lower strike) bull call spread is that while there is no additional upfront cost, you must be willing to forgo any additional profit potential above $90; the maximum potential loss remains the same ($3,500). However, the breakeven price is lowered by five points (to $88.50) and XYZ has to be below $85 (down from $90) at expiration in order to sustain the maximum loss. Finally, the unrealized loss remains at -$1,620 and the maximum gain is only $1,500 (rather than unlimited).
You are bearish
If you’ve completely changed your perspective on XYZ and are now bearish, you might consider converting the original long call position into a bearish call spread by selling some lower strike calls.
Buy 10 XYZ July 90 calls @ $3.50 (to open) ◄original position
Sell 10 XYZ July 85 calls @ $4.25 (to open)
Net credit = $4,250 (4.25 x 10 x 100)
Days until expiration = 37
Breakeven = $85.75 (short strike + net credit from both trades) or ($85 + $.75)
Maximum loss = $4,250 (difference in strikes – net credit from both trades) or ($5,000 – $750)
Maximum loss occurs at $90 or above at expiration (stock is bought at 90 and sold at 85)
Maximum gain = $750 (net credit from both trades) or (-$3,500 + $4,250)
Maximum gain occurs at $85 or below at expiration (all options expire worthless)
Net new position
Source: Schwab Center for Financial Research.
Now, the stock is already moving in the right direction, and at its current $85 price, is already slightly below your new breakeven of $85.75. Your original strategy was for XYZ to exceed $90, but if that occurs now, you will sustain your maximum loss. The new bear call spread strategy brings in a net credit, but your maximum potential loss actually increases by $750 (from $3,500 to $4,250). In addition, your risk has increased and your maximum profit is now limited to only $750 (versus unlimited previously), which occurs if XYZ is below $85 at expiration.
Stock stays flat
If you now feel that XYZ might just stay around its current level, you might consider creating a long call butterfly spread by entering a new ratio call spread.
Buy 10 XYZ July 90 calls @ $3.50 (to open) ◄original position
Sell 20 XYZ July 85 calls @ $4.25 (to open)
Buy 10 XYZ July 80 Calls @ $8.00 (to open)
Net credit = $500 (4.25 x 20 x 100) – (8.00 x 10 x 100)
Days until expiration = 37
Lower breakeven = $83 (middle strike – max gain) or ($85 – $2.00)
Upper breakeven = $87 (middle strike + max gain) or ($85 + $2.00)
Maximum loss = $3,000 (net cost of all trades)
Lower maximum loss occurs at $80 or below at expiration (all options expire worthless)
Upper maximum loss occurs at $90 or above at expiration (1,000 shares are bought at $80 and sold at $85 and 1,000 shares are bought at $90 and sold at $85)
Maximum gain = $2,000 (middle strike – lower strike – net debit from all trades) or ($5,000 – $3,000)
Maximum gain occurs at exactly $85 at expiration (1,000 shares are bought at $80 and sold at $85)
Net new position
Source: Schwab Center for Financial Research.
The effect of turning your original long call position into a long call butterfly spread is that if the stock remains relatively flat, you’ll end up in the profit zone. While hitting maximum profit on a long butterfly is virtually impossible (in this example, XYZ would have to be at exactly $85 at expiration) you have a four-point range ($83 – $87) over which it could be profitable. But if the stock moves above or below this range, you will sustain losses. If XYZ is above $90 or below $80 at expiration, you will sustain your maximum loss of $3,000.
Because additional trades needed to create this butterfly bring in a small net credit ($500), your maximum potential loss from your original long call position decreases by this amount. Additionally, your unrealized loss also goes down by $500 to only -$1,120. While your risk has gone down slightly, your maximum profit is now limited to only $2,000.
A call option will benefit from :
- Make adjustments early
- Don’t move the losing side
- Always take in a net credit
- Re-center whenever possible
- Widen the break-even points
- Positive Delta – C
Option Basics
How do you defend a credit spread?
A call option will benefit from :
- Adjust when the short strike reaches a 30 delta
- Turn the trade into an iron condor with same contacts and width. Center the iron condor at the new stock price.
A call option will benefit from :
- Make adjustments early
- Don’t move the losing side
- Always take in a net credit
- Re-center whenever possible
- Widen the break-even points
- Positive Delta – C
Option Basics
How do you defend a short straddle?
Principles of managing a short straddle:
- Roll the unchallenged side toward the challenged side
Notes
- Do not be too aggressive with time timing or the degree of managing the trade as you will want to guard against the trade moving back toward what was the unchallenged side.
- Only manage the adjustment for a credit
- Adjusting for a credit moves the break even point in your favor
Option Basics
How do you defend a strangle?
A call option will benefit from :
- A rise in stock prices
- A rise in volatility
- An early rise in stock price ( time kills the stock value )
- Positive Delta – Call prices rise when the stock price increases, which benefits the call buyer. Conversely, call prices fall when the stock price decreases, which is not good for the call buyer.
- Positive Gamma – A long call’s position delta gets closer to +100 as the stock price increases and closer to 0 as the stock price decreases.
- Negative Theta – The extrinsic value of options decays as time passes, which is detrimental to a call buyer
- Positive Vega – An increase in volatility will increase the value of a call option ( indicated by positive vega ). Conversely, a decrease in volatility will decrease the value of a call option ( indicated by a negative vega
Option Basics
How do you defend a butterfly?
Principles of managing a short butterfly :
- Move the unchallenged side toward the challenged side for more credit.
Trade Logistics:
Rolling down the put side ( the challenged side ) is wrong
- The value of the put side decreases as it gets challenged. If you roll it down and out, you will be locking in a loss on the roll because you will first have to close the put side for a loss. You will then have to re-open lower for less credit.
- But if you roll down the call side ( the unchallenged side ), you will be doing so with an increased credit. First, the unchallenged side is worth more as the stock price moved away toward the challenged side. By closing the unchallenged side, you will be locking in a profit. And by re-opening the trade closer to the challenged side, you will be opening a new trade with an improved credit.
Option Basics
How do you defend a an iron condor?
Principles of managing an iron condor :
- Move the unchallenged side toward the challenged side for more credit.
Mechanism:
- Rolling the unchallenged side of the iron condor toward the challenged side will:
- increase the credit
- widen the break even point on the challenged side because you increased the credit
- the iron condor will become taller and wider
Trade Logistics:
Rolling down the put side ( the challenged side ) is wrong
- The value of the put side decreases as it gets challenged. If you roll it down and out, you will be locking in a loss on the roll because you will first have to close the put side for a loss. You will then have to re-open lower for less credit.
- But if you roll down the call side ( the unchallenged side ), you will be doing so with an increased credit. First, the unchallenged side is worth more as the stock price moved away toward the challenged side. By closing the unchallenged side, you will be locking in a profit. And by re-opening the trade closer to the challenged side, you will be opening a new trade with an improved credit.
- Moving the put
Option Basics
How do you defend a Calendar Spread
Principles of managing a calendar spread :
- Adjust the front month short strike when it decays in value by more than 50-75?
- Roll the put side closer to to the stock price ( does not have to be at the stock price )
Mechanism:
- Rolling the unchallenged side of the iron condor toward the challenged side will:
- increase the credit
- widen the break even point on the challenged side because you increased the credit
- the iron condor will become taller and wider
Trade Logistics:
Rolling down the put side ( the challenged side ) is wrong
- The value of the put side decreases as it gets challenged. If you roll it down and out, you will be locking in a loss on the roll because you will first have to close the put side for a loss. You will then have to re-open lower for less credit.
- But if you roll down the call side ( the unchallenged side ), you will be doing so with an increased credit. First, the unchallenged side is worth more as the stock price moved away toward the challenged side. By closing the unchallenged side, you will be locking in a profit. And by re-opening the trade closer to the challenged side, you will be opening a new trade with an improved credit.
- Moving the put
Buying a Call
Management and Adjustments
- With premium selling strategies, defensive tactics revolve around collecting more premium to improve our break-even price, and further reduce our cost basis.
- With short straddles, we don’t have much wiggle room because the short options are already on the same strikes. One option is to roll the whole straddle out in time, using the same strikes.
- This can be done for a credit, and we will hope for the stock price to return to our short strike by the new expiration.
Short Straddles
The Greeks
- Neutral Delta – Delta measures directional risk. For every dollar increase in the stock, the option price will increase by the delta value. The short call will have a negative delta. The short put will have a positive delta. Because they basically cancel each other out ( neutral strategy ), the overall delta is around zero. .
- Negative Gamma – A short options position gamma gets closer to 0 as the stock price increases and closer to 1 as the stock price decreases.
- Positive Theta – Theta indicates how much an option will change per day. Short contacts gain value with time and with the approach of expiration. The extrinsic value of options decays as time passes, which is beneficial to option sellers. Time decay increases as you approach expiration
- Negative Vega – Vega measures the change in the options price for every 1% increase in implied volatility. In other words, for every 1% increase in implied volatility, the option will increase by the amount of vega. Short straddles are negative as they profit from a decrease in implied volatility. Long straddles are positive as they profit from an increase in implied volatility.0
