Last week's Options 101 article discussed trades that go bad right away. Employing the example of the iron condor strategy, the article illustrated an SPX iron condor trade entered November 20 and in trouble by the trader's guidelines by the next day. Those guidelines included adjusting when absolute value of the delta of a sold strike was over 16. For those who don't watch the Greeks of the options, the idea would be that the theoretical loss was already escalating too much. As a review, here's the trade as of November 21, with the reminder that profit-and-loss (PnL) line turns red when the planned maximum loss is hit:

Trade as of November 21, the Day After Entry, OptionNET Explorer Chart:

Some adjustment possibilities included the following:

Buy a long call.
Roll one or more of your sold calls five points higher, only five points away from your long calls.
Put one or more call debit spreads in front of your sold calls.
Buy in some of your call credit spreads.
Roll one or more of your call credit spreads to higher strikes.
Realize that this trade isn't going as expected, going bad so early in the trade, so close it with a minimal loss.

Last week's article illustrated buying an extra long call, putting one or more call debit spreads in front of the call credit spreads, and buying in one or more of the call credit spreads. As homework, I also suggested that interested readers might model the possibility of moving some of the sold calls up five points.

What about just biting the bullet and moving all the call credit spreads to a higher strike? A problem soon arises, in that case. First, let's look at what we're buying back and selling. The blue numbers under "Pos" detail the current positions. The green numbers under "Model" detail the process of buying in the sold call credit spreads and selling new ones at higher strikes.

Options Chain, OptionNet Explorer:

You might notice that the credit for the new sold spreads is $0.575 while it cost $1.275 to buy to close the in-trouble spreads. There's very little credit available if the trader wanted to swing those new call credit spreads even higher, as the trader likely would like to do. Now let's look at what this choice does to the expiration chart and profit-and-loss (PnL) line, with the new expiration graph in green and the original in blue.

After Moving Flies:

As had been true of the adjustments illustrated in last week's article, the delta risk has been reduced. Delta has been raised to -16.38 from the original -40.82. The planned maximum loss is not hit until about 1821, a bit sooner than with the other adjustments, but still far enough out to provide some breathing room. Theta has been reduced, but not as much as with a single long call purchase. However, potential profit has been drastically reduced. Maximum potential profit has now been reduced to $850.00 minus commissions. Moreover, risk has been increased due to the locked in losses. The increased risk shows up in the green expiration chart, when the green line flattens out below the original blue line.

I don't know. To me, that chart is looking as if I'd have lots of risk for not very much profit. This is especially true since less premium is available now for selling credit spreads.

In the days before the spring of 2010, when the iron condor was still my trade of preference, my personal guidelines for trading iron condors included selling up to double the amount of original credit spreads when I had to move credit spreads. I would calculate how many I needed to sell to make up for the locked-in loss of buying back those in-trouble spreads and sell enough new credit spreads, up to double the amount, to make up that loss. That kept my profit potential the same, but it also increased my risk. I always left plenty of money in my account for such adjustments, leaving at least half and usually two-thirds of the trading account in cash when I made the original trade.

In this case, even selling double the amount of original credit spreads does not make up the loss. It brings the potential profit up to $1,425 minus commissions, however.

Moving Credit Spreads and Selling Double the Amount of New Ones to Bring in Credit:

This time, I've removed the legend on the left-hand side of the chart to better display the two versions of expiration graphs. We see right away that the delta has not been reduced by this choice since we've sold double the amount of call credit spreads so that we preserve more premium and possible ultimate profit. This trade is going to hit the planned maximum loss at about the same point as the original trade.

That's not the biggest problem. The risk is dramatically increased, as evidenced by the green expiration chart's track on the right-hand side of the chart. Although I could generally trust myself to pull the plug when a trade went bad, what happens if the SPX gaps higher and runs hard the first few minutes of trading the next day? Let's remove the original expiration chart and look at what would theoretically happen if the SPX gapped up and ran up another 14 or so points the next morning.

Theoretical Gap Higher on Nov 22 after Rolling into Double the Number of Call Credit Spreads:

The "x" along the PnL line marks where the loss would be if these theoretical conditions were fulfilled. The loss has jumped to $1,252, only about $130 away from the original planned loss of $1,380. The delta is now -68.04, so it wouldn't take much of a change in price to hit that maximum loss before you even have time or can break out of your shock and paralysis long enough to close the trade . . . or get a trade filled even if you acted right away.

What's even worse is if volatility changes push the trade past your planned maximum loss. Although implied volatilities usually drop on a gradual rally, a morning gap and sharp rise sometimes keep extrinsic value high in the calls as everyone tries to buy them. Implied volatilities stay artificially inflated and may further hurt the trade momentarily at least, rather than helping it. The shocked trader can soon be past the loss she ever intended to take and price can be sliding down that long slippery downhill slope toward more and more losses. See how much deeper the loss can be on the upside rather than the downside? That's because of the doubling of the call credit spreads sold.

Each of us can make up our own minds. I was always careful about the amount of cash I left for adjustments and I tended to make those adjustments when needed, not being the type to be paralyzed. But then came a month when I moved spreads and moved spreads in trades that spanned two expiration months and woke up one morning to runaway markets, to losses more than I intended to take. I did have enough money to move everything one more time, but did I want to double my risk again to move sold credit spreads just a few points higher? Did I want to do that when the markets had proven they were likely to run away beyond any normal market behavior?

I didn't want to do that, I finally decided, after giving the markets a day to change directions. I'm glad I didn't make that choice. If I had, all my talk about trading since 2010 would likely have been theoretical and not due to actual experience with live trades. If I'd made that choice to roll all those many credit spreads higher again, I would have lost an unimaginable chunk of my trading capital. I would have had enough money left to trade, but I don't know that I would have had enough confidence left. As it was, I lost a chunk of my confidence in myself and my guidelines.

Doubling credit spreads as an adjustment tool more than once is not a choice I would advise because sometimes the thing that just "can't happen" and "hasn't happened in X years of backtesting" does in fact happen. Doubling credit spreads the first time should be done only if the trader is fully cognizant of the increased risk and the trader's account and confidence can absorb the bigger hit. Of course, instead of doubling the call credit spreads, one could move up the put credit spreads to help bring in more premium at the same time that one was moving up the call credit spreads. Think carefully about that tactic, too, because markets that are shooting higher can turn around and run down hard, too. When you're making a choice that adds more risk, make careful decisions about how much risk you're willing to take.

Then there's the last choice. When a trade goes really wrong, really quickly, it is sometimes a viable choice to take a small loss, realizing that your view of the market behavior is wrong for some reason. You can sit back and evaluate and get back in when you think normal conditions have reasserted themselves. This is not the same as caving in each time your trade shows a small loss. In iron condor trades, especially, those far out-of-the-money options can vacillate in prices a lot, and the first day or two of trading, the PnL can change a lot, moving rapidly from small gains to small losses, sometimes due to bogus pricing on far out-of-the-money options that aren't actually actively trading. But the iron condor is a trade that depends on probabilities. When those probabilities are proven wrong right away and the only adjustment possibilities seem to add too much risk, it's appropriate to ask yourself if the trade should be exited. There's no one right or wrong choice. Each has pros and cons. Traders should evaluate them, thinking about risks, their market views, and their risk tolerances, before making a choice, realizing that trades sometimes continue to go wrong even after adjustment.

This is true of other trades, too, but the iron condor is particularly hard to adjust. Some traders are finding that they prefer to start the iron condor differently than the traditional iron condor, perhaps selling fewer call credit spreads than put credit spreads or adding one or more call debit spreads in front of the call credit spreads when the trade is first initiated, not when it's already in trouble. I'm not experienced with trading these types of iron condors, but you might backtest such choices and see if one of them appeals to you.

Dot Hazlin from the Couch Potato newsletter under the Option Investor umbrella of newsletters sometimes advises closing a trade that isn't working rather than taking on more risk. She's got a good handle on this topic, so it might be worthwhile to follow some of her trades, too (on paper, if you're not familiar with her trades) to learn how another trader thinks about these matters.

Linda Piazza

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