I'm going to be talking Greeks again, but not in a complicated way, I hope. I want to address some of the ways you might cut the risk to your position brought about by an adverse price move. In order to do that effectively, we have to talk a little about deltas. Delta measures how much your position will theoretically be helped or hurt by a certain price movement.
I want to affirm again my status here. I don't claim to be an expert on the Greeks of a position. Instead, I represent the traders who are educating themselves about the Greeks, learning how that knowledge can benefit their positions. I also want traders to recognize the "theoretically" part in the description of how delta works. Delta levels can be impacted by changes in volatility and other factors, so that a price movement doesn't change the value of the position in the expected way.
With those caveats out of the way, let's dig in. For the sake of discussion, I'll be using the mid-price level halfway between the bid and the ask. I know it's unlikely we'd get those mid prices on anything but the most liquid markets on the quietest trading days, but we have to have some basis of comparison, and that's what I've chosen. We're going to brainstorm. Some ideas will prove unworkable; some, slightly more so. Each will have pros and cons. It's the process that's important here.
Suppose at the end of the day on Wednesday, April 7, you banked on the typical overnight running-higher of the futures. With the RUT closing the day at 699.46, you bought 10 contracts of the RUT APR 10 690 calls for $13.45.
By 9:58 am ET the next morning, that position was deeply underwater. The Greeks of the position showed you that it was long 570.31 deltas, and the option that had a mid price of $13.45 the day before now had a mid price of $9.60.
What did the 570.31 deltas mean? It meant that the entire position would regain $570.31 for each point the RUT climbed, but it would lose $570.31 for each point the RUT dropped. This number would probably hold over about a point, but then the delta would change a little for each move in the RUT. For now, we'll treat the delta as if it's static over short price movements.
Obviously, in a dropping market, this high delta rate meant that the value was not just leaking value but was bleeding it profusely. Suppose the trader who had that position thought the RUT could still bounce, but wanted to reduce the risk from the price movement? How could the deltas be reduced?
The easiest manner would be to reduce the size of the position. Closing the position entirely removes all risk, of course. It also locks in the loss on all 10 contracts, but sometimes stopping the bleeding is the most important task you have as a trader. Selling five of the contracts reduces the delta to 289.62. That slows down the price-based risk a bit. It also locks in a loss on those five contracts.
There are going to be pros and cons to each suggestion here, and that's true of this one, too. Decisions must be made in the context of balancing those pros and cons for each trader. We may think we know what's going to happen in the markets, and sometimes our best educated attempts at technical analysis prove to be right. Sometimes, however, the market doesn't behave as rationally as we think it will, and the technical analysis we've done and the scenarios we envision just don't pan out.
Suppose we still suspect that a rally is going to occur and we don't want to lock in a loss now? We hold 10 calls. Let's just be creative in our thinking and so some brainstorming. Some such ideas we consider will need to be discarded. Let's see.
We could sell higher calls against those 10 we hold. For example, theoretically that morning, we could have sold 10 APR 10 700 calls for $4.30. We would then have a bull call debit spread. This would cut the delta of the whole position down to $209.73. But does the position make sense? Per contract, the cost of that spread would now be $13.45 - $4.30 or $9.15, plus commissions. What's the most we could make on that position? The most we could make per contract would be $10.00 - $9.15 = $0.85 per contract minus the commissions we paid. Furthermore, we'd collect that only if the RUT settled at or above 700 at APR settlement.
Of course, we know now that this adjustment would have worked as long as commissions weren't too high and didn't detract too much from that $0.85 profit per contract. But was it a viable solution, a good risk, at the time? Maybe not. What if the RUT had settled at 692 rather than the somewhere-north-of-700 where it surely settled? (Settlement values for the RUT are later than for other European-settled indices and aren't out yet as this is being uploaded.) The long 690 call would have been worth $2.00, and the sold 700, nothing, but that meant that a loss of $9.15 - $2.00 = $7.15 plus commissions would have been taken. This manner of cutting the deltas just doesn't seem a good risk to have taken in this particular case, at least to me, but it might have been if the trader had been able to jump in earlier in the morning when selling that 700 call would have brought in more money. This is a solution that can be considered in some circumstances, but its pros and cons must be carefully weighed. In this case, I wouldn't have taken this action.
Maybe as of that morning when you woke up to lower prices, you're not so bullish any longer, and you believe at the time that the precipitous drop means that the RUT is getting ready for another big move. But will that move be to the upside or downside? You look at charts and you see all kinds of possibilities. The RUT has just retraced about 38.2 percent of its climb off the April 1 low, so no real damage has been done even on a short-term basis. The RVX has jumped, but is dealing with channel resistance that turned it back on April 1. And, historically speaking, the RVX, the RUT's volatility index, isn't high enough to signal that its options are too expensive.
You decide to somewhat neutralize your deltas by buying a RUT APR 10 690 put, putting on a straddle. Your delta is now a more moderate 144.45. However, you'd have paid $7.00 for each contract of that put, for a total of $13.45 + $7.00 for the straddle. That's $20.45 plus your commissions. That means that at expiration, the RUT would have to settle at above $710.45 (plus whatever you paid in commissions) or below $669.55 (minus whatever you paid in commissions) for you to profit from that new position. It would have to make that movement quickly, too. Think-or-swim's analyze page suggests that by the Monday of April's expiration week, the position would have been down $8,668 if the RUT were to languish at the then-current 694.15 level. Ouch. Of course we now know that the RUT did not languish and this seems like a genius tactic, with the RUT soaring just above 725 on Thursday, April 15. But was it such a genius tactic when first being considered that day a couple of weeks previously? Attempting to ameliorate the losses amped up the potential losses rather than cut risk. For some people, this tactic might have been one they wanted to try, but I don't know that I would have been willing to take on that extra risk.
Let's go back in time again and think about that morning when the RUT had dipped and those calls were deeply underwater. If you had turned extremely bearish, you could have sold an ITM APR10 680 call for $17.70 against the long call you already held. This would have produced a total credit for the position of $17.70 - $13.45 = $3.55 minus the commissions you paid. If the RUT settled below 683.55 minus the commissions you paid on April's expiration, the position would break even or make money. The deltas of this new position would be about -183.24, showing that you would now benefit from any drop in price. However, TOS's risk analysis charts show that if the RUT were to languish at its then current price into the Monday of option expiration week, the position would show a loss of about $3,675. If the RUT soared higher, so would the loss. The loss would never grow as high as the straddle position's potential loss could have grown, being limited to $10.00 between strikes - $3.55 credit = $6.45 per contract plus the commissions paid, but that was more than the loss that morning when we were hypothetically casting around for a way to ameliorate the loss. This setup would have required a strong bearish action in what had been a bullish market. To be profitable, it would have required that the RUT drop steeply from its then current level and stay below a specific level into expiration. While it's good to brainstorm and think of all the possibilities, some must be excluded, and this was one that should have been.
There were pros and cons to each of the tactics considered here. Personally, if I'd been in a directional trade and the market action had proven my reasoning for entering the trade was wrong, I probably would have just felt that the best way to reduce risk was to take off the trade. But what about a more complex trade that hadn't been put on with a directional bias? What about an iron condor, for example? What if prices were zooming too close to one sold strike or another, so that the unrealized loss was mounting?
As of the morning of April 8, my May SPX iron condor had a delta of -77.72. That 50-contract position wasn't in trouble but what if it was? What if I were still afraid of an unstoppable upside move and decided to take advantage of the pullback that morning by flattening my deltas? I could do that by taking off some of my call credit spreads. Taking off 20 of them, collecting the itsy-bitsy profit I had in them so far after putting them on a few days previously, I would flatten the deltas to -16.66. Since there was still a lot of time value left in those credit spreads, I would also cut down the earning potential of that iron condor. Still, if something leads me to believe that my original premise for putting on the strikes where I did might have been flawed, then this is a possibility.
Taking off parts of spreads is also a tactic that can be considered to lower the delta-based risk on other types of complex trades. When Dan Sheridan talks about iron condors and butterflies on CBOE presentations, he talks about taking off some of the spreads or moving them to lower the price-based risks. My recent experience with rolling would lead me to add caution about rolling into a greater number of contracts than one had initially, however. Using a risk-analysis or profit-loss chart can allow you to experiment with how many contracts to reduce or determine the new placement of rolled-out contracts. Many brokerages now offer such risk-analysis graphs. Some traders also use OptionVue, which tends to be expensive. I have used the freeware OptionsOracle, which can be a bit clunky at times, and doesn't offer the back testing capabilities of OptionsOracle. However, it is still versatile in testing current trade adjustments and immensely helpful when making these decisions.
What if I'm going to be away for the day, unable to check my positions or even talk to my broker after an alert sounds, and am worried about the possibility that the SPX could pull one of those maneuvers like it did in November, 2009, moving up 20 points in a day? I could temporarily neutralize my deltas by buying a next-month call position with about that many deltas. For example, I could buy a JUN 1140 call option to flatten my deltas to -4.52. It would cost me a hefty amount to do so and would temporarily murder my profit-loss chart, but it's a possibility I could consider if I had no other alternatives. Doing this flattens out the profit/loss curve to the upside so that the position is not going to be hurt by more than a few dollars over a one-standard-deviation move to the upside. Too large a drop would begin to tack on negative deltas, of course, and my theta, the time-decay element, would be temporarily butchered.
This wouldn't be a tactic I'd likely use with the absolute values of my sold strikes at 10 or under. However, it would be and has been a tactic that I've used when the danger is more extreme. I have at least once just bought back a sold spread to wait out a particular development. That removed all the further risk from an adverse price movement, but no choice is without pros and cons. What if there's a strong movement that would have been advantageous? What if some development means that there's not a good spot or time at which to replace the spread? I mention just buying back a sold spread, just as one would sell a directional call or put position, because I don't think it's a tactic that many traders have previously considered, but it's not without risks. We get wedded to the positions that we have placed, thinking that we have to stick with them, have to manage them, no matter what. In some cases, it's better to remove them and reposition them later, but only if the pros and cons of such an action are strongly considered.
These are far from the only tactics available to reduce price-based risk. These may be the worst tactics to try and some of you may have much more educated suggestions for ways to moderate such losses. My only purpose was to get you thinking about all the choices that options give you. Options are extremely risky products, but we're rewarded for that risk by trading a product that's also extremely flexible.
To get you really thinking about the pros and cons of various choices, I would suggest a book that I've recommended previously: The Option Trader's Workbook by Jeff Augen. This isn't an easy book, but it truly is in workbook form. Augen presents several setups, asking readers lots of what-if type questions in which you're asked to determine the next best course for a certain position. If you have trouble thinking out of the box with options positions, as I sometimes do, Augen's questions will help you think with more flexibility about your choices.