Hey everyone.
This is Kirk, here again at optionalpha.com.
In this video tutorial, I want to talk about when to adjust an option trade because I know
that after placing a new trade, the next question that’s on most traders minds is, “When
should I make an adjustment or hedge?”
If necessary, of course because if a trade is going great, then you’re obviously going
to let the trade go all the way to expiration and have a nice profit.
But if a trade is going bad, at what point do you really step in and make an adjustment
to that trade?
There's two general categories that we have to put these adjustments into to begin with.
I think we always try to categorize everything by risk defined trades which would be trades
that are credit spreads, iron condors, calendars in some cases, debit spreads, anything where
you know exactly how much you can make or lose because with those types of trades, you
generally want to be slower and this is just a rule of thumb.
You generally want to be slower with your adjustments.
You don’t want to be too quick to make adjustments because you already know how much money you
could potentially lose.
And if you're placing trades at the right high probability of success level, then ideally,
you could actually just let them go all the way to expiration and you’d be okay.
When it comes to naked or undefined risk trades, so these would be your strangles and your
straddles, any strategy where you're selling options on either end and you don't have that
additional long option as protection, then you need to just be a little bit quicker with
your adjustments and that’s just a rule of thumb.
It’s not saying that you have to make adjustments every single day, but you should just probably
watch those positions a little bit closer.
What's been helpful to me personally over the last eight years is just having a set
of guidepost or road markers that alert me to make an adjustment or hedge trade.
The reason I set this up in advance is because I want to take my emotion out of the game.
We’ll go through a couple of the different ways you can do it here in a second.
But when I setup one of these alerts, as soon as I get a notification of a certain barrier
being hit or a certain Delta being hit, then I automatically make an adjustment.
There’s no thought in here as far as, “Well, maybe the market might come around or maybe
the stock might rally or fall.”
There’s none of that.
Take your emotion out of the game.
As soon as you get the alert, make the adjustment.
Here's a couple of ways that you can do it.
Again, we will use some of these interchangeably here, there’s no one set way to do it, but
these are the ways that we've seen a lot of traders do and probably some really good ways
to do it.
This is all assuming that you're making very high probability of success trades to begin
with.
The first way that you can do it is you can make an adjustment when the short strike of
your spread (whatever spread you have) reaches a 30 Delta.
In our case of most of the trades that we enter, we’re entering trades at about a
15 Delta or a 15% probability of losing on either end.
The trade reaching a 30 Delta means that our probability of losing has doubled.
And for us, that’s a good trigger point to make an adjustment because we originally
had a 15% probability of losing that's now moved up to a 30% probability of losing, so
at that point, we might want to consider making an adjustment.
The second way you can do it is if you’re a little bit more aggressive, you would say,
“I’ll make an adjustment at a 40 Delta.”
Whatever position you enter originally, you might make that adjustment at a 40 Delta.
This is also the case where if we make a trade that's an 80% chance of being a winner and
a 20% chance of being a loser, we might set that new adjustment level to a 40 Delta because
that's a doubling of our probability of losing.
The third way that you can do it is if your initial credit on the trade is increased by
two times.
I often see some people use five times or three times, but we just use maybe two times
or three times as just a guidepost or road marker to use.
But if you initially took in a $.30 credit and now the spread is trading for $.60 or
is trading for $.90, whatever it is, you use some sort of initial credit multiplier as
to when you can make an adjustment.
The fourth way to do it (and this is a really easy way if you’re a beginner) is that you’ll
make an adjustment if the stock violates your long strike.
If the stock goes all the way through a short strike and goes all the way through your long
strike, you’d consider that a pretty big move and you’d want to make an aggressive
adjustment at that point.
Let’s actually go over couple of those different ways that we can make that adjustment with
a recent trade that we just put on in SPY.
We literally just sold a call spread above the market in SPY and you can see that SPY
is trading at 201 right now and we’ve sold the 208/209 call spread above the market.
This trade has a probability of being in the money of about 23%.
When we actually made the trade, it was about 20%, just rallied towards the end of the day,
so it’s about 23% probability of being in the money.
Our Delta on the original position was about 20, so my personal point at which I’m going
to make an adjustment on this trade is if this Delta which is currently at 25 reaches
40 because that's going to be a doubling of my probability of losing.
I can visually see how far the stock needs to move for that to be about what happened.
You can see finding a Delta of about 40 right now is equivalent to a stock at 204.
If the market goes from 201 up to 204, so about a $2 move based on where it’s at right
now, I might see a doubling of my Delta.
That’s just an approximate that you can use, so you can watch the market and say,
“If it moves up another $2 today, maybe my Delta will go up to about a 40 and I might
want to make an adjustment.”
But if I was a little bit less aggressive, I might want to do something at a 30 Delta
and you can see it’d only take less than $1 move here to get the market up to about
a 30 Delta on my short strike because we’re just focusing on that short strike which is
the 208 call.
In the third example, we can use some sort of multiplier for the credit of the spread.
We originally took in $.30 on this $1 widespread, it’s pretty normal to take in, that's a
pretty average trade for us.
If we use a two times or three times multiplier, then we might look to make an adjustment if
the spread’s value increases to $.90 or $.60.
Somewhere in there, we might look to make an adjustment.
The fourth way that you can do it is if the underlying (in this case, SPY) violates your
long strike.
In this case, SPY would have to go from 201.63 all the way up past 209 which is your long
strike here.
Remember, we sold the 208/209 call spread, so in this case, we only make an adjustment
if the market gets all the way up to 209.
You can see that’s probably maybe waiting just a little bit too long to make an adjustment,
but it’s going to be different for different people and your own trading styles is going
to dictate how quickly or how slowly you make adjustments to these positions.
But this is a really good example of how we can do it in all four different cases that
we outlined and what that might look like.
Remember that the key here is to have something in place as far as rules, so that you can
systematize your trading.
We've got a ton of resources and guides inside of optionalpha.com that you can sign up for
and get for free downloadable PDFs as far as how to make adjustments to each of the
different strategies that are out there and we’ve also got a ton of video tutorials
on a lot of these topics as well.
If you want more information on how to make adjustments and including when to make adjustments
on particular strategies, you can check them out at optionalpha.com.
As always, I hope you guys enjoy these videos.
If you have any comments or questions, please add them right below.
I’ll get back to all of those, so that you guys get the answers you need in a timely
manner.
Happy trading!