I'll never forget sitting beside my broker when I was attending a seminar for iron condor traders. He was there representing his brokerage. I'm paraphrasing his statement as follows: "Traders don't realize that they have options besides just waiting out a trade in trouble and hoping that it turns out all right or closing it and taking the loss."
We don't have to take a loss when a trade goes wrong any more? No, that's not what he meant. He meant that traders could--and should--be more creative when faced with a trade going wrong. Through the years of writing for Option Investor, I've talked freely about some of my own efforts to discover ways to adjust losing trades. However, in this article, I want to move the focus from specific adjustments to training ourselves to be more creative, of thinking outside the box. Options are flexible instruments that invite creativity.
I used to be more creative. When faced when a math or physics problem, I knew just how to go about solving it. I would first make sure I understood the problem to be solved. I would get to work breaking down the problem into knowns and unknowns. I would write down formulas I might need in solving the problem. Then I would start plugging knowns into those formulas and solving for the unknowns. I would brainstorm.
We can use the same kind of thinking when we're faced with a losing trade. On page 60 of Jeff Augen's The Option Trader's Workbook, Augen goes through just such a process when posing possible adjustments when a long call purchase occurs and the underlying subsequently drops. Rather than adjustments, Augen terms these possible strategies "defensive actions."
Most of you know that although I'm currently going through the process of diversifying the strategies I employ, the majority of my positions remain iron condor trades. Many of you may also know that such trades are composed of two credit spreads, a bear call credit spread and a bull put credit spread. I typically want to collect about $1.20-1.40 for my iron condors, and then I put in orders to buy-to-close each side when that side's value narrows to $0.20. Depending on the original credit I take in and the conditions as the trade progresses, I may occasionally pay a few cents more if my order for $0.20 looks as if it should be filling but isn't. That cent or two more may be enough to get me out of that spread, locking in most of my credit and taking away that side's risk.
I placed an order for 30 contracts of a RUT JAN iron condor on November 20, with the order filling at $1.40. By December 15, I was able to close the 30 bull put spread contracts for $0.21, so I did so, locking in my profit on that side and eliminating the risk from that side. On December 18, I placed an order to close the bear call side for $0.20. I felt that the RUT and other indices might be temporarily bottoming, a thesis that turned out to be right, and I wanted out of those bear call spreads if the RUT was going to go on another tear to the upside. I had on other iron condors at the time, and was placing orders to exit the bear call portion of 40 SPX iron condors, too. The SPX orders were filling, but the RUT ones weren't. I upped the order a few cents, but only three contracts had filled by the end of the day. The rest, as they say, was history, as my assumption of a temporary bottom turned out to be right. The RUT took off to the upside.
On January 7, 2010, I found myself in a predicament. My trading plan determines when an iron condor or credit spread needs to be adjusted by delta levels. The RUT hadn't hit my adjustment point, when the absolute value of the sold strike hits 0.22-0.25 (or 22-25, depending on your quote service). Yet, the RUT was only about 21 points from the sold strike. A standard deviation of one day was a little less than 8 points, but just a few days previously, the RUT had posted a gain of 17.89 points. Anything in the 8-17.89 range was likely to get me into an adjustment level. Moreover, the all-important jobs number was due the next day. The RUT could easily gap higher and run strongly, as it had earlier in the week or it could roll over, in which case my credit spread would likely narrow and the position would be fine.
What were my choices about defensive actions? I brainstormed. I could do nothing, since my adjustment level hadn't been reached. I could close the spread, since a gap higher and run up the next morning might turn a profitable position into a losing one. I could close just part of the spread to reduce my risk. I could delta-hedge by buying a FEB long position to hedge half to two thirds of my deltas, somewhat inoculating the position against a loss if the RUT gapped higher the next morning. Another choice was to adjust by rolling into a spread at higher strike prices or by rolling up and out, into a spread at a higher strike price and in the next month, the FEB's. I could get even more creative and turn the credit spread into a quasi-butterfly by buying a debit spread composed of the following actions: buying-to-open a strike below my sold strike and selling-to-close an equal number of contracts at my long strike. There were probably many other choices I haven't mentioned here, too.
Let's look at some of the possibilities.
I ruled out the "do nothing" choice right away. It just wasn't right for me. To make that choice with the RUT so close to the sold strike and with so little time remaining until option expiration, I would have had to be hoping that the RUT was going to retreat the next day and I wouldn't get caught by a gap higher or a run up of the kind that had happened just a few days previously. I try to be as dispassionate as possible about my trades so that I'm not operating on hope.
I compare this predicament to one that many face in many businesses. For example, my son-in-law's company has been asked to present proposal after proposal to another company, but the other company just never follows through. Although each contact seems promising, my son-in-law's company eventually decided to stop responding to the requests because so much manpower and resources were being devoted to preparing all those proposals, all for naught. Maybe it was time for me to just abandon this trade, too, locking in the little bit of unrealized profit I still had.
At the time I was considering these actions, I still had about $2795 in credit left in the position. This was the credit left to me after having bought put insurance when I established the position and then paid to exit the bull put credit spread and the three contracts of the bear call spread I had managed to unload that one day. Closing out the other 27 contracts would have cost $2224, leaving me only $571 in credit but removing all risk. Closing half the position would have left me with $1683, but I still would have had almost $15,000 at risk if the RUT ran up the next day and into option expiration week.
Ultimately, because a standard deviation move to the upside would have presented problems and because capital preservation is my main goal at this stage in my life, I elected to close the whole position. Looking at some of the other choices I had may show why I made that choice.
Delta hedging was one possibility I had considered. The left-over position, 27 bear call spreads, was short about 196 deltas. If I'd chosen to buy 80-130 long deltas to hedge that risk, I was going to spend some serious money. For example, at mid price, a RUT FEB 600 call would likely have cost about $47.80 and had a delta of 0.82. Buying one of those would have cost $4,780 plus commissions, more than the total credit I'd originally taken in for the whole iron condor.
I do occasionally delta hedge. Especially if there's risk overnight of a big move that I think might or might not then get reversed after the first 30 minutes or so of trading, I'll sometimes delta hedge in this way. I draw from my old day trading skills to tell me when it's appropriate to do so and when to get out of that delta hedge or when to use it to ameliorate losses while I close the position if a reversal doesn't look imminent.
In this case particular instance, the chart signals were mixed. The RUT was closing the day jammed up near the 1/5 high, ready to either pull back again from that level or leap above it and charge toward next resistance. The RVX, the RUT's volatility index, was ending the day not too far from potential support on daily closes. The jobs number the next day might roil the markets, with the direction as yet unknown. In this case, it seemed too risky to delta hedge with a long position that was so expensive.
I strongly considered buying a debit spread to create a quasi butterfly position, but ultimately discarded that possibility as just not right for me. This was because, once again, anything at all could have happened after the jobs number. My original sold strike was the RUT JAN 660 call and I had bought RUT JAN 670's. I could have bought RUT 650's and sold an equal number of 670's. The profit/loss graph for the original position before considering this tactic was as follows:
Expiration Profit/Loss Graph for Remaining 27 Bear Call Credit Spreads from Original 30 Contracts of Iron Condor:
When I put a debit spread in front of or straddle an existing credit spread to adjust that credit spread, I usually try for about one-third the number of contracts of the credit spread. If I had elected to buy 9 RUT JAN 650's and sell 9 of my RUT JAN 670's, I would have created a position that was long 9 RUT JAN 650's, short 27 RUT Jan 660's, and long 18 JAN 670's. The cost would have been about $2597 with commissions. The new profit loss chart would be as follows:
Expiration Profit/Loss Chart After Buying a Debit Spread:
Although the profit level on the left side of the chart is not clearly visible here, the profit if the RUT retreated would have been reduced to just under $200. A settlement value of 660 would have produced a profit of about $9,013. After 665, however, the profit/loss graph dropped like a stone through negative territory. If the RUT's settlement number were near 670, the position loss would theoretically be about $8,800.
That's still far less than the almost $27,000 that would have been the loss if the original position hadn't been adjusted and the RUT's settlement were at 670 or above. Some charts suggested that the RUT might be headed toward 660, with my daily Keltner chart giving a potential upside target of 663, but that chart also showed RSI beginning to flatten after reaching above 70. Bearish price/RSI divergences were showing up. While I thought 660 might be possible before option expiration or a settlement number near there on settlement Friday, I also thought a bad reaction to the jobs number could undo any thought of reaching that potential upside target. Should I collect my $571 now, adding it to the far healthier profits I'd made on other trades that month or try this tactic? In my own case, where capital preservation is premier, I still elected to exit the full trade ahead of the jobs number.
In most cases when I adjust, I elect to roll the spread out of the way by rolling into a higher strike in the same expiration month, perhaps at 1.5 times the number of contracts. What about rolling up into the JAN 670/680 bear call credit spread? When I looked the day in question, the mid price of that spread was at only $0.35. Rolling into 45 or even 30 of those contracts for $0.35 original credit on each just didn't make sense from a risk/reward standpoint. I just don't take on that amount of risk for that little credit. These days, I expect at least $0.50 for each side of a credit spread and hopefully more.
What about rolling up and out? Other than delta hedging with next-month long positions, I make it a practice to keep all profits and losses from one month's trades in that month's options. I don't carry it forward into the next month. I eliminated that choice right away. Besides, I was already in my FEB RUT iron condors, already having determined how much risk I wanted to take on for FEB expiration.
These aren't the only choices, of course. For example, I could have delta-hedged with TF futures rather than options, but they would have been expensive, too. I could have altered that quasi-butterfly strategy in many ways, by employing fewer or more contracts, for example. The choice that is right for a certain situation or a certain person might not be right for someone else. I have a newly born fifth grandchild, and I'm spending a lot of time on the road between my town and my daughter's town as I help out in the household. With a retired husband, capital preservation is of utmost concern. So, I'm not suggesting that my choices were the "right" choices.
I'm suggesting that we have choices. Play around with different ideas. Brainstorm even if you're worried that some of your ideas might be too risky or just plain dumb. Chart the choices on a risk graph. I use think-or-swim's or Option Oracle's (free). If you've come up with an unfamiliar adjustment, be sure to talk about its pros and cons with your broker, as there may be risks you didn't perceive.
Those losses? You don't always have to take them sitting down. Be creative in looking for ways to avoid or lessen a loss.