Last weekend's article recalled the school days refrain of "why do I have to know this," when applied to working with equations. This week, I'm reminded of some of the lessons from my first physics classes. The third of Newton's laws of motion told us that for each and every action, there's an equal and opposite reaction. Just as we need to understand something about working with the put-call parity equation, we need to understand that for each and every action we take with adjustments on options strategies, we create an opposite reaction, if perhaps not an equal one.
That's especially true when we're considering whether to roll a credit spread. Although I'm not trading live this month, I typically enter my iron condors about 55-60 days before expiration. For my 25-contract iron condors, I sell the first call with a delta less than 10 and the first put with a delta less than 9. I spend about 10 percent of the premium I collect for the purchase of an insurance put. If I had used those guidelines for a theoretical RUT JAN iron condor established on 11/23, 58 days before JAN expiration, I would have ended up with an 810/800/600/590 iron condor, with an extra 590 put as the insurance put. After paying theoretical commissions of $1.25 a contract, I would have ended up with a credit of $3,361.50 available.
By Thursday, December 02, that trade would have been in trouble. Take a look at the delta on the sold call.
BrokersXpress Theoretical Data for the RUT JAN 800 Call:
I tend to consider an iron condor trade in trouble once the delta of the sold call reaches 0.22 (or 22, with some brokerages). Although the delta wasn't quite that high, the propensity of markets to gap up or down in the mornings makes me more cautious when an adjustment level is approached at the end of the day. If the RUT were to gap down the next morning, this theoretical trade would have benefited. If it gapped up, the trade might have been in a world of hurt the next day, depending on what happened with volatility. The theoretical loss on the position was already 9.80 percent, and the portfolio delta, as shown on a charting system I use, was -114.48, which would have meant that the position would theoretically have lost almost $114.48 more for each point the RUT moved higher. This negative vega position wouldn't likely have benefited from a drop in volatility as the RUT climbed if it gapped open in the morning. These huge morning gaps have tended to hike volatilities, at least temporarily.
If I'd actually been in that trade, I would have been making an early adjustment that afternoon of December 2. I probably wouldn't have waited until the position deltas were so negative, either, but might have adjusted earlier in the day. Depending on how I viewed the markets, I might have hedged half the position deltas. I could have accomplished that by various methods, including buying back enough of my sold calls, purchasing a call or call debit spread with enough deltas or by rolling the call spread higher. For the sake of argument, let's say that I rolled the spread up a couple of strikes, selling the 820 and buying the 830. Let's say that I also rolled into 30 contracts instead of the original 25 to help pay for the debit.
According to one P/L charting system, that leaves me with a position with a delta of -89.09, down from the -114.48. That's better, but it's not really good enough, is it? In addition, I have only $1,727.50 in available credit left after I rolled. The delta on the new sold call is only 11.29, so although that's slightly hotter than I like to sell my calls, it's not a huge problem yet.
The put credit spread has narrowed. It could be bought back for a profit and then rolled higher. What would be accomplished if, in this theoretical trade, I rolled up the put credit spread? If I sell the first available put with a delta higher than -9.00, I'll be selling the 640 and buying the 630. After also rolling the insurance put, I'll be left with $2,017.50 in available credit, and my position delta will now be -74.47 rather than the previous -114.48. It's obvious from this example that we must include rolling the opposite spread in our arsenal of possible methods to reduce delta or price-related risk.
What else has changed while the delta risk was being reduced? The position is also much more negative vega, -478.78 rather than the previous -392.40. That means that if the jobs report or an overnight European crisis had tanked the markets the next day and implied volatilities had expanded, that trade was going to get into trouble on the downside much more quickly. If the theoretical pullback had been a quick one only to 725, with a sharply rising volatility, one theoretical P/L chart showed that the loss could easily hit my maximum 11 percent of the margin withheld. In fact, if the volatility rose hard enough, that maximum loss level could be hit without price moving much because those 30 call spreads would widen, too.
What if I didn't roll up into the full 25 put credit spreads, but instead rolled up into only about half, 13? The position delta eases to only -95.59, but the new vega isn't as negative, either, at only -392.26. My maximum credit would theoretically be $1,321.50. In this case, according to one P/L chart, a theoretical drop that next trading day to 725 with sharply rising volatility wouldn't worsen the potential loss, and a drop into the 700 area might even help if it the vols didn't rise too much. But I'm not going to make much profit, and I have a risk that's higher than my original risk because of the 30 contracts I took on and the lesser credit I have.
What if I've got some prior knowledge of something I believe will hit the markets hard? What if I were so bearish that I think the RUT is going to roll over and roll over hard? I certainly don't want a full allotment of those rolled-into bull put spreads and I maybe don't want to roll any bull put spreads up any higher than their original 600/590 level.
Each decision has ramifications. You push the position into a more bullish state by rolling up some or all of those put spreads, and it's going to push you back, hard, if the RUT rolls over hard. I'm personally leery of rolling spreads because through the years, many of my losses have come from rolled spreads. However, I've talked to others who have shown me they benefit by always rolling both spreads any time they're required to roll one out of the way. They also roll each time a spread narrows enough that it makes sense to take profit, and they feel that such rolling enables them to always replenish the iron condor with plenty of capital. Each time you roll such a credit spread, you're locking in a realized gain. Since some medical issues prevented me from trading live this month, I've been experimenting with a paper trade in which I'm rolling put spreads up each time those spreads narrow to $0.20, locking in some profit. So far, it's been helpful when I've also needed to roll up a few call spreads that were threatened, keeping the theoretical delta or price-related risk at bay. However, we also haven't seen a hard rollover during that time period, so this test hasn't been a thorough one.
We don't have rights or wrongs. We have decisions to make. Just realize that if you push the trade one direction, it's going to push back against you if the underlying reverses.