I study all kinds of articles and blogs. Recently, one blogger, an experienced options guy, complained that "those who tout rolling [credit spreads] ignore the risks when explaining how it works" (Wolfinger). In fact, on other sites, those who tout lots of options trades ignore the risks. We don't.
Trading options can be risky business, so your first goal as an options trader is to assess the risk you're assuming. We options traders don't want to go the way of those financial companies that assumed too much risk leading into 2007 and then found their business model blown apart. Even those trading straight puts or calls, whose only risk is the amount they spend on the option purchase, assume risk of blowing through a trading account if losses aren't kept small in relationship to gains. The smaller the account, the more assiduous the option trader must be about managing those losses, because some studies indicate that the risk of ruin--the risk of running through a trading account--rises as the size of that account decreases.
Whether you trade options fulltime or part-time, trading options is a business like any other, and it should be treated as a business. That's a credo that former market maker Dan Sheridan drills into listeners to his CBOE and OIC presentations.
Let's talk specifically about rolling. Because I'm most familiar with iron condors and because trading iron condors over the last year has prompted even more familiarity with rolling, we'll use iron condor trades as the examples.
Whatever method you use for determining when one side of an iron condor is in trouble, all iron condor traders are sooner or later going to find themselves in a situation where it's either time to bail or time to adjust on a trade. Statistics may be in your favor, true. However, that just means that hopefully far more months will go by when you don't have to adjust than will months when you do have to do so.
Rolling a credit spread, one side of an iron condor, down or up is one method of adjusting, but there will always be addition risk when you roll a credit spread. Those addition risks consist of one or both of the following: additional time in the trade and additional financial risk. The additional time in the trade results in almost any case in which you adjust almost any trade. During that additional time in which you're waiting for the newly adjusted trade to work, you're exposed to the possibility that this new trade, too, might go wrong. You're also losing the opportunity to use the money that's tied up in that trade in another trade that might produce more income.
The first question to ask, then, is whether the money you're tying up when making an adjustment and trying to avoid a loss might be better utilized in another trade. If you stop thinking of yourself as a failure when a trade fails, it's easier to divorce yourself from shame or humiliation. It's a business: some business contracts fall through, some sales are cancelled, some clients demand services that eat up all the profit. Losses occur in every business model. If we stop feeling shame when a trade fails, we can more calmly assess whether it's a good business decision to take on this risk of increased time in a trade and the inability to put the money we're using in the trade to another use.
Then comes the other question: whether we're assuming increased financial risk and whether it's okay to do so, if we are. Sometimes I use examples from my own trading, but I haven't rolled any iron condors in a couple of months, so I'm going to create a hypothetical situation in which an iron condor might need to be rolled. I use the deltas of the sold strike to tell me when an iron condor needs to be adjusted. On the call side, I tend to adjust when the delta of the sold call reaches 0.22 to 0.25 (or 22 to 25, if your quote source automatically multiplies by the 100 multiplier).
Since I tend to put on my iron condors about the same time each month, I made up a typical position with typical costs that might now be in trouble, inputting my actual commissions I would have paid if I'd actually entered this position. Remember that my articles are roughed out ahead of time, so all the examples in this article were derived from conditions as of January 20.
The theoretical position consists of the following SPX options: + 20 FEB 1180 calls, -20 FEB 1170 calls, -20 FEB 940 puts, and + 20 FEB 930 puts. The credit was $1.40 per contract, with the assumption that the absolute values of the deltas on both the sold call and sold put were at or just under 0.10 at the time the trade was initiated. The total credit would have been $2,800 but, with my own commission schedule, the commissions would have been $100.88. Therefore, the total buying-power effect would be as follows: $20,000 (10 points between wings x 20 contracts x 100 multiplier) - $2,800 credit received + $100.88 = $17,300.88. The total credit received (reported as a negative debit) and other trade parameters as of the close on 1/20 are shown in the following table:
Strategy Summary as of 1/20:
By the time that summary had been snapped, time had passed and prices had moved. According to the delta level of the sold call (0.2436), it was time to adjust this iron condor. It may actually have needed adjusting a day earlier when the SPX was zooming up ahead of the Tuesday elections. Unfortunately, the free OptionsOracle does not give me option prices from the previous day, so let's go forward with what we have. We can see that our theoretical loss on the position is now $2,101.76, as of the time this material was prepared. This isn't a $2,101.76 deduction from the $2,800 received in credit but rather a much bigger loss that was partially offset by the $2,800 credit. The credit is wiped out and there's an additional $2,101.76 loss. This can get confusing on iron condors which brought in a credit when established, so I wanted to emphasize this point.
Some iron condor traders set their maximum loss at 1 to 1.5 times the typical credit taken in each month, and some set that maximum loss at a percentage of the buying-power effect. For example, if I'm typically taking in $2,800 in credit each month on an iron condor and statistics tell me they're likely to be profitable about eight months out of ten at the delta levels that I use, then it's reasonable to risk 1 to 1.5 times the typical credit that I take in, in a losing month. If my maximum profit potential is 15.02 percent, as this chart tells me, then it's perhaps also reasonable to risk the current 12.15 percent loss in a bad month.
In actuality, I never, ever, ever just let a credit spread run into expiration, or at least I haven't done in the many years since I changed my iron condor trading plan. That means I'm never going to keep all that profit and collect 15.02 percent on this iron condor.
However, this $2,101.76 loss is one I would still consider below my maximum loss. If this had been an actual trade, I could have elected to adjust it by rolling the credit spread, but there are a number of questions to ask myself. Am I going to roll the bull put side, too, or just close out that side and keep the profit in that side?
When I roll, am I going to roll into a position that has the same risk parameters as the original position, the same 0.10-or-under delta on the sold strike and same number of contracts? Or will I be willing to assume more risk in order to make up more of the debit that I'll lose by closing out the going wrong bear call spread?
The answer to those questions depends on a trader's comfort level, trading experience and account size. I'll tell you flat-out right now that after a strong rally, I'm rarely comfortable with rolling up the put side and, if I do it, I do it in half the original size. Why? With a strong rally, I'm going to be afraid of a reversal, and reversals are typically harder and more brutal than rallies, as many have learned the last couple of weeks.
The answer for me to all these rolling questions is that, in the environment we had as of 1/20, with big, more-than-a-standard-deviation moves for several days in a row, my choice would have been NOT to roll the bull put credit spreads. I would have closed those. As of 1/20, they probably could have been closed for $0.10 to 0.15, but let's assume the more conservative $0.15. Actually, in most cases, when one side of an iron condor gets into trouble, I've already long since closed out the other side, since I do so when the spread narrows to $0.20, and I can close and lock in most profit.
Newer traders without experience rolling contracts might elect to roll just half the bear call spread, too, rolling into a spread with the original risk parameter, having a sold call with a delta of about 0.10 or under. Doing that is not going to make up for the loss in the spread that went wrong, but it will ameliorate the loss. In fact, some newer traders might just elect to close the spread and take the loss on the iron condor for that month, knowing that this manageable loss would be made up in other months of gains.
Let's assume, however, that the bear call credit spread was rolled, all 20 contracts, into the next spread with the same risk parameters as the original. As of 1/20, that would have been the 1195/1205 bear call spread. OptionsOracle tells me that all the transactions, to close the whole original iron condor and to roll into 20 contracts of the 1195/1205 bear call spread, would have resulted in a debit of $3,250 plus $151.32 in commissions. If I deduct from this the $2,699.12 amount that represents the original $2,800 credit - $100.88 commissions to establish the original iron condor position, there's still a $702.20 loss. That loss represents a locked-in loss that is the best that is possible for this trade. If the spread narrows before expiration and a choice was made to exit it, a debit would have to be paid and that would add to the loss, although hopefully only minimally.
No gain is possible, but still the loss is narrowed, which is important. However, it's important to note that the risk remains the same or nearly the same as in the original trade. If the SPX continues to charge higher, through the new sold strike, there's still the risk to 20 contracts with 10-point wings.
Is that an acceptable risk to take to lock in a smaller loss? The answer to that question will be different for different people and for different circumstances. To some people, it certainly will be enough. In fact, my biggest failure to follow through my own trading plans occurred late last spring when family health difficulties hit at the same time I was managing two months' worth of iron condors that needed adjusting. I closed out the offending spreads more or less appropriately, given the gapping markets and slippage. However, my concentration was so scattered that I was afraid that I wouldn't be able to attend to additional trades, so I didn't roll anything, even into a same-contract-size-same-delta-risk new credit spread. That decision resulted in bigger losses than I should have suffered, and I would have been happy, after all the drama had ended and I was past that time, to have locked in a smaller loss.
However, my personal trading plans calls for a more aggressive roll if the offending spread is the upside one, appropriate only because I've been trading these so long. For example, if this hypothetical position were an actual position, I might have chosen my typical tactic, which is to roll into about 1.5 times the original number of contracts on the upside, if I feel that the rally has been extended and might be due for a pullback. OptionsOracle calculates that closing the original iron condor and rolling into 30 bear call contracts at the 1195/2005 strikes would have resulted in a total debit of $2,525 plus $176.12 in commissions, for a total debit of $2,701.12. If I deduct this from that $2,699.12 original credit after commissions, I'm about at breakeven.
I've essentially wiped out the loss, but I've actually increased my risk. Because there are 30 contracts now, I have about $30,000 in risk since I've wiped out all the previous loss but also all the previous credit I'd received for the trade. Good tradeoff? On the face of it, it's not. I can imagine some situations when this might be okay, but I really want to be rewarded at least something for increased risk. It should be noted here that if I'd felt comfortable in this hypothetical situation in rolling up the put side, even into half size, some credit would have been available for this trade. However, I would have felt uncomfortable with that tactic when this article was first roughed out about ten days ago, and the price action since that time has proven why I'm so leery about rolling up the put side when I've rolled a call spread that got into trouble.
Another possibility, but a far riskier one, is to roll into a spread with totally different parameters than the original one. For example, instead of rolling into the 1195/1205 bear call spread, with the FEB 1195 call having, at that time, a delta of 0.098, just under 0.10, I could have considered rolling into a spread in which the sold call had a higher delta. That would have brought in more premium. For example, if this had been an actual position, I could have rolled into an 1185/1195 spread. As of the close on 1/20, that 1185 had a delta of 0.15.
This part of the article should flash one of those "don't do this at home, professional racer on a professional track" warnings. This is not an appropriate adjustment for anyone but the most experienced iron condor traders with plenty of funds left in accounts for adjustments.
After all was said and done, commissions and fees paid according to my commission schedule, OptionsOracle tells me that closing the original spread and rolling into 20 of the 1185/1195 bull call credit spreads would have resulted in a total left-over credit of $597.80. In this case, the risk is $20,000 - $597.80, so not very much below the original risk, with a whole lot less possible credit than I originally had. Still there was some credit.
However, if the SPX keeps climbing, this new credit spread is going to get to a new adjustment point much faster than one established with a sold strike with a delta of about 0.10. Once that delta moves to about 0.15, it ticks up rather fast with each point change in the SPX.
What would happen if I had theoretically rolled into 30 of those bear call credit spreads at the 1185/1195 strikes, with the 1185 having the delta of 0.15? This time, OptionsOracle calculates the debit to close the iron condor and roll into this new bear call credit spread position to be $575.00 + $176.12 in commissions, $751.12 in total. Deducting this from the original $2699.12 in total credit after commissions, I would be left with a maximum possible credit of $1948. On the face of it, that's a more encouraging potential reward, but in this case, the increased financial risk is twofold: from a greater number of contracts and from the greater delta on the sold strike.
Is this risk acceptable? That would be acceptable only for the most experienced traders with plenty of cash in their accounts in case the new position got into trouble and needed to be rolled, and only in certain market setups. I have used this tactic, but only after many years of trading iron condors; many years of observing how delta changes when price, time and volatility change, and many years of watching topping behaviors. Plenty of money needs to be left in the account for future adjustments, such as purchasing a long back-month call position to hedge deltas. Sadly, plenty of money needs to be left in case this spread gets into trouble, too, and needs to be closed. Some inexperienced traders get into trouble by not leaving enough money in their accounts to close out an offending iron condor trade, and have to do it in small lots, freeing up buying power before they can move on to the next lot. Don't do that.
The risks are various with each of these choices. I've talked about increased financial and delta risks, but I believe there's another risk to be factored into these choices. I once was told that each trader has a comfort level as to the number of contracts and it's possible that comfort level may never be exceeded, no matter how many years that trader trades and no matter how many successes are behind that trader. I liken it to driving. No matter how many years I drive, you're probably not ever going to find me tooling along the highway at 95 miles per hour. If I were speeding along the highway at that speed, I'd likely be the kind of driver who'd get scared and close my eyes, even though I'd rate myself fairly highly as a driver at 70 miles per hour.
Subscribers should also consider the risk of getting scared and closing your eyes when you're considering taking on more time, financial or delta risk when rolling. Will you feel comfortable being trapped in that rolled-into trade another two weeks if that extra two weeks brings you perilously close to expiration week? Will you feel comfortable taking on 1.5 times the original number of your contracts if you've never traded that many contracts, or will you stay awake all night listening to CNBC Asia and Bloomberg, watching futures levels scroll across the screens? Or, if the absolute value of the delta on your new sold call is 0.15, are you going to shut down your computer and go into another room if the underlying's price ticks up and the absolute value of the delta does, too, right along with it? If a standard-deviation move the next day is going to bring you right up to the brink of another adjustment, will you run into the next room and fall down in a fetal position?
I'm not even exaggerating much here. While I haven't run into the next room and fallen into a fetal position when I took on more risk than I ultimately felt comfortable taking, I've most certainly stayed up all night watching futures level scroll across a Bloomberg screen on television. Life's too short. Don't do anything that causes that kind of angst. This is just a business. It's not life threatening.
In a business, losses occur, so we should all get over the feeling that we're a failure when a trade needs adjusting. Just remember that all adjustments add risks and decide before an adjustment is needed which risks are appropriate for you and your situation.
One further note: there's a reason I used the example of rolling a bear call spread in this article and not a bull put spread. I would rarely ever roll a bull put spread in the same day if it were going wrong and even more rarely would I roll into more contracts than I had originally and even more rarely than that would I roll into a bull put spread with a delta of -0.15 or lower. I can't guarantee that I've never done that, but I certainly don't remember doing so.
If prices are barreling lower, they can barrel lower very fast, and volatilities are typically rising as that happens. Rising volatility increases the absolute value of deltas fast and widens spreads fast. Exit going-wrong bull put credit spreads sooner than you would the bear call side, and be much more conservative about rolling down, if you elect to do so at all. Some people who rolled down during parts of the last two years were sorry they did so.