THE OPTIONS COURSE- Increasing Your Profits with Adjustments

THE OPTIONS COURSE


Increasing Your Profits with Adjustments

You can create the best trade in the world, but what you do after the trade is placed is crucial to your success. When you put on a trade that is perfectly delta neutral and the market makes a move, it changes your overall position delta. Your trade is no longer delta neutral. At this point, you can choose to maintain or exit the trade, or return to delta neutral by making adjustments. To bring a trade back to delta neutral (a position delta of zero), an adjustment can be made by purchasing or selling options and stocks (or futures) to offset your position. Determining which adjustment to make is a decision dependent on analysis and market experience.

In general, when delta neutral trading guides your decision-making process, you know when and how to make an adjustment to your position. To a certain extent, adjustments are the real meat of delta neutral trading. As you become more experienced with this process, your profits will reflect your increased proficiency. This is where the professional floor trader needs to excel to survive. Off-floor traders have more time to think about and execute the optimal hedge. When you are trading delta neutral, it can be helpful to think of one side of the trade as your hedge and the other side as your directional bet.

In many cases, even if you are 100 percent wrong about market direction you can still make a profit. I prefer to hedge with the options and bet on the direction of the stock (or the futures). Theoretically speaking, if the market moves 10 points up or down, you should be able to squeeze the same amount of profit out of the trade. However, when you start factoring in things like time decay and volatility, this figure may change. For that reason, the trader will often adjust the position in order to shift back to neutral. Let’s consider some examples.

VARIABLE DELTAS

Before we show some working examples of adjustments, keep in mind that there are two types of deltas: fixed deltas and variable deltas. A fixed delta means something that never changes, something that always stays the same. For example, if you buy 100 shares of XYZ selling at $25 per share and then sell it for $30, you will have 5 points deposited into your account, or $500. Conversely, if you buy 100 shares at $25 a share and it goes down to $20, you lose 5 points—$500 will be drained out of your brokerage account. Either way, the delta of the shares remains the same. This is a fixed delta. Buying and selling futures is also an example of fixed deltas. The deltas will remain at +100 for each 100 shares of stock you are long and –100 for every 100 shares you short sell.

What is a variable delta? Deltas change because of the passing of time and due to market movement, which also changes prices. Options at different strikes have different deltas that vary as the underlying security changes. If you buy 500 shares and sell 500 shares at $25 per share, your overall position is delta neutral. But there’s something faulty in this reasoning. This kind of trade goes flat. Although this combination creates an overall position delta of zero, since both deltas are fixed, this trade cannot be adjusted, and will not increase or decrease in value. Options, in contrast, have variable deltas that change as the underlying price moves.When the overall position delta moves away from zero, you can apply adjustments to bring the trade back to delta neutral and thereby generate additional profits. 

As we have already discussed, delta is at the cornerstone of learning delta neutral trading. As previously shown, one future or 100 shares of stock has a fixed delta of plus or minus 100 while ATM options have a delta of plus or minus 50. If you buy 200 shares and get a delta of +200, you can buy four ATM puts or sell four ATM calls to create a delta neutral trade: 200 + (4 × – 50) = 0. The type of options you choose determines whether the position has a long or a short focus. The plus or minus sign of the delta depends on which direction best takes advantage of the market circumstances. Buying a call or selling a put takes advantage of a rising market and therefore has a corresponding plus sign. 

Buying a put or selling a call takes advantage of a decreasing market and therefore has a minus sign. Mathematically, this is quite easy to understand. But why do deltas act the way they do? Perhaps a simple analogy will convey the meaning of a delta. When you slam on the brakes of your car, the process from the time you hit the brakes until the time your car stops is like a delta curve. Near the end of the stopping, you tend to experience more deceleration than when you first hit the brakes—even with antilock brakes. Right at the precise point where you completely stop, everybody kind of jogs forward a bit for a little whiplash action. This is exactly like the movement of a delta at expiration.

ADJUSTING A STRADDLE

One of the advantages of trading straddles is the ability to easily adjust them. The adjustment process is designed to bring in additional profits while maintaining the delta neutral status of the trade. The adjustment strategy used depends on a wide variety of trade specifics. A delta neutral trade is one in which the overall delta of the combined position equals zero. This means that both sides of a delta neutral trade balance each other out, thereby reducing the overall risk of the trade. The trade makes money when one leg of the trade moves in-the-money enough to pay for the cost of placing the overall trade. Straddles and strangles are non directional delta neutral trades that rely on increases and decreases in volatility movement to make a profit.

Straddles use ATM options with identical strike prices and expiration dates. A long straddle is usually applied in markets where a large price movement is anticipated; but the direction of the move is unclear. Upon entering a straddle, the underlying stock price changes to some degree in one direction or the other. As the price fluctuates, the position is no longer delta neutral. An increase in the underlying stock price creates a positive delta, and a decrease creates a negative delta. The trade thereby changes its nature to becoming either bullish or bearish, and the resulting profit becomes more reliant on the future direction of the underlying stock. Let’s look at an example to see how an adjustment can change this scenario. 

If you’re holding a straddle and the price of the underlying stock rises, the delta becomes positive and you have a profit on the call side of the position. At this point you may not want to lose the profit you already have, so you have three choices:

1. Close the position, take your profits and move on. Although this may be the most prudent move to make, you can no longer participate in any future moves. You have put a limit on your gains, as well as your losses.

2. Sit tight and do nothing. Just continue the trade, hoping the price will continue to rise and your profits will increase. If the price goes up, the trade is a winner. If the stock takes a nosedive, you are risking your profits. If the price of the stock declines, you may lose your profits, and perhaps some of the original premium due to time decay.

3. Adjust the position. There are several ways to do this. The idea is to continue in the trade while simultaneously capturing profits and returning the overall position delta to zero.

These three alternatives possess their own respective advantages and disadvantages. Often the best choice can only be determined by hindsight. But since the key to profitable trading lies in assessing the available choices, learning the benefits of adjusting can help you to become a more profitable trader. Options with various strikes have different deltas, and these delta amounts change as the underlying asset’s price fluctuates. The object of the delta neutral game is to keep your trade as close to zero deltas as possible. When the next uptick changes the market you are trading, you are no longer neutral.

That means that you may be able to make an adjustment by purchasing or selling calls, puts, or stock shares to get the trade back to delta neutral. Adjustments are much easier to make when you have placed a trade with multiple contracts. They enable traders to lower the overall risk of the trade, and in some cases, start the spread over again at a new price. If there’s a profit on the table, an adjustment can allow you to take it and still keep the overall risk of a trade low. If the price continues to rise, you can still benefit from the bullish movement. 

Conversely, if the price declines, there are ways to profit from a reversal rather than lose.  As a delta neutral trader, I have often found it profitable to adjust my straddle positions. Since a straddle is already a combination trade consisting of at-the-money (ATM) puts and calls, there are many alternatives by which adjustments can be made. All adjustments, however, fit into two categories: adjusting with options or stock. The adjustments further break down into positive or negative changes depending on what is needed to bring position delta back to zero.

Adjusting with Options

Straddles have a large theta risk because the time value of the options is constantly declining, which results in lost premium. Since adding more options increases the theta decay, you can decrease it by making adjustments through selling options that are already owned. If the price of the stock has increased since the last adjustment, you can reduce the delta by selling some of the calls and taking profits. If the price of the stock declines, simply sell some puts to increase the overall position delta. 

Selling options provides an additional major advantage: You can put your cash back to work by investing in new positions. The number of options to be sold depends on the overall position delta in relation to the deltas of the specific options. All options are provided a delta relative to the 100 deltas of the underlying security. If 100 shares of stock are equal to 100 deltas, then the corresponding options must have delta values of less than 100. Selling options does have two basic disadvantages: commissions and slippage. Most traders pay a certain minimum commission when trading options—typically $10 to $30. 

If the adjustment involves the sale of only one or two options, this can become a significant amount. In addition, the bid/ask spread on options is an eighth or higher, sometimes as much as a whole point. This can also have a detrimental effect on the profitability of the position. Since you are working with a spread, it can be difficult to be precise with adjustments because the calculations involved in trying to pinpoint the price at which the contract should be sold are often problematic.

Adjusting with Stock

Adjusting a straddle with stock is a fairly easy to understand process and usually less difficult to execute. If the straddle becomes too delta positive (long), shares of stock can be sold. If the straddle becomes too short,stock can be purchased to easily adjust the delta. The calculations of when to make an adjustment are much easier: When delta gets to 100, a sale of 100 shares of stock will bring it back to zero. Commissions on buying and selling stocks have become so low, thanks to the advent of online brokerages, as to hardly be of any concern.

Many online brokers will execute a trade for less than $10. The bid-ask spread is typically a sixteenth and the savvy trader can get a price executed exactly when the trader wants. Although selling options might appear at first to be the best way to make adjustments, for the reasons just mentioned, many traders have found that adjusting with stock is the most efficient way. Option software and spreadsheets can be produced that can very easily indicate all of the possible adjustments needed in the trading day, before the market opens.

Adjustment Targets

There are three main triggers or targets that you might consider using to make adjustments in a spread position: delta-based, time-based, and event-based targets. Each one has a unique set of advantages and disadvantages that can be employed to advance your profitability. 

Delta-Based Adjustments

The straddle is constantly monitored for its position delta. Using option software, you can watch how the price of the stock changes, which triggers market makers to change implied volatility. In the process, the delta of your position is recalculated. When the delta reaches a predetermined level—usually 100—you can adjust the position by buying or selling stock or options to return it to delta neutral. Many traders do their calculations at the beginning of each day, identifying the exact stock prices at which the delta will change by 100, and place orders to buy or sell stock at that point. 

This allows the orders to be placed in advance and automatically executed at the proper levels. The trader does not have to follow the stock tick-by-tick to find the adjustments; they will just happen. The major advantage of this method is that it is exact and mechanical. The position never acquires more than plus or minus 100 deltas, thereby capturing profits as they occur. You can also take advantage of intraday swings in price. No judgment or decisions are necessary because the adjustments are automatic. 

The main disadvantage used to be the time it took to do the calculations. But technology rules the day. This process can be computerized into a spreadsheet, even the number of trades that are made and the resulting commissions. But another disadvantage rears its ugly head: Delta-based electronic trading does not allow for positions to spontaneously “run” or take advantage of the higher deltas from a large move in the stock. This, however, is the type of directional risk that we are seeking to avoid. 

Time-Based Adjustments

A simple method is to make delta adjustments according to a time schedule. At the end of the morning, the day, or the week, a calculation is made to bring the position back to delta neutral. The major advantage is simplicity, but many opportunities for adjustments between the scheduled times might be missed. 

Event-Based Adjustments 

This method is used quite frequently to adjust positions that would not ordinarily be adjusted. A special event makes such an adjustment important in preserving profits. For example, the release of an earnings report increases a stock’s market volatility. In fact, stock prices often run up or down in anticipation of the upcoming report, and if the report catches Wall Street by surprise, the stock might reverse direction altogether. 

In this case, just before the report, an adjustment can be made to capture the profits in the straddle that have resulted from the preannouncement volatility increase and resulting move in the stock. By returning the straddle to delta neutral, you can benefit from a continued run, or even more important, from the reversal that seems to occur frequently around these reports. For example, let’s say you have a straddle on a stock, with a strike of 50. The earnings report will be on Monday, and the stock has moved to 60 in anticipation of a great report. 

You could choose to be optimistic and hope that the report will be a surprise to the upside, and the stock will increase even more. But what if the report triggers a sell-off? You’ll lose your profits. If you do your delta calculations—sell some stock or options to bring the position back to delta neutral—by Monday you won’t care which way the stock moves; you will benefit either way!

Bottom line: Adjustments can be excellent ways to reduce your risk of losing hard-earned profits, and even increase them further by benefiting from reversals.

ADJUSTING LONG SYNTHETIC STRADDLES

You can create a long synthetic straddle by selling 500 shares of XYZ at $25 and buying 10 June XYZ 25 calls at $2.20. This is a perfectly hedged delta neutral position that enables you to make money in either direction (with calls to the upside and the short shares to the downside). Remember, as long as you use long options—puts or calls—it is a long synthetic straddle. I prefer to use ATM options because they have high liquidity and are easy to work with. High liquidity increases the probability of profit and fosters better pricing because the price spreads are thinner. Price spreads are the difference between the bid price and the ask price for which you, as a trader, can buy and sell options, futures, or shares.

As an off-floor trader you will typically buy at the higher price (the ask) and sell at the lower price (the bid). Meanwhile, floor traders typically make their money by purchasing from you at the bid, and selling to someone else at the ask, or vice versa. In other words, when we refer to price spreads, we are really talking about the bid and ask prices. In the last 30 days before expiration, an ATM option is actually the most liquid option out there. Although ATM options have the highest liquidity, liquidity tends to taper off similar to a bell curve; the further out-of-the-money or deeper in-the-money you go, the less buying and selling occurs. 

The spreads become a lot wider. You can look at something that is two strikes out-of-the-money and there could be half a point difference between buying and selling it. This means that you are automatically down half a point in your position as soon as you initiate the trade. That’s why I highly recommend initiating a delta neutral trade by using ATM options to offset stock positions. They are more liquid and should have a narrower spread between the bids and asks (offers).

Let’s return to the long synthetic straddle example composed of the sale of 500 shares of XYZ at $25 and the purchase of 10 June XYZ 25 calls at $2.20. In this trade, you have –500 (5 × –100) deltas on the short stock side and +500 (10 × +50) deltas on the options side for an overall position delta of zero. If the stock moves up 5 points, its delta is still –500. It doesn’t change, because it’s fixed. The only time it changes is when you alter the position by selling existing, or purchasing additional, shares. The variable deltas are your option deltas. 

The ATM calls are +50 each. If the underlying stock moves up 5 points, the calls become in-the-money with a higher delta of approximately +70 each for a total of +700 deltas. This means that your overall position delta is +200. To bring the trade back to delta neutral, you can make an adjustment by either selling 200 shares or selling three of the ATM calls you already own. Either choice realizes an increased credit into your account. If the market makes another move, you will be able to make another adjustment to increase your profit even more. This adjustment process locks in profits.

Adjustment Example

Let’s explore another example using XYZ. Suppose the stock is about to break out or move above its all-time high of $90 a share. You decide to place a long synthetic straddle. With XYZ trading for $90, the July 90 calls are priced at $3.75 and the July 90 puts are priced at $2.75. You decide to initiate a 5 × 10 position (i.e., 500 shares of XYZ stock and 10 XYZ options). Once again, you have to choose which options have a better profit potential: puts or calls. You decide to purchase the shares and buy ATM puts. On the stock side, you have +500 deltas, which will be offset by 10 long ATM July 90 puts for a total of –500. The overall position delta going into this trade is a perfect zero. 

The total risk is the premium paid for the 10 put options, or $2,750. On April 14, XYZ closes at $95. The July 90 calls close at $6.875 and the July 90 puts close at $2. The positive delta is still +500. Since you are one strike out-of-the-money, the negative deltas have moved to –35 each for total deltas of –350. Your overall position delta is now +150. You make an adjustment to get back to delta neutral by selling 150 XYZ shares for a profit. Now you own 350 shares of XYZ and the 10 puts originally purchased. What is your cash settlement up to this point? Right now, it is relatively easy to calculate the cash settlement. 

You started with 500 shares of XYZ at $90. Then the price went up 5 points and you sold 150 shares for a $750 profit. The puts are now at $2. You lost .75 point on the puts, which equals $750. That means you have broken even on this trade so far, but still have 350 shares of XYZ at $90 showing an open position profit of $1,750. On April 26, XYZ hits $105 a share. The July 90 calls are now at $11.50 and the July 90 puts are now going for $1.625. Your 350 XYZ shares have a positive delta of 350. The puts are now at –250 because you’re three strikes out or –25 each. That gives you a position delta of +100. Let’s make another adjustment by selling 100 more shares of XYZ at 105. 

What is your cash settlement to date? You started with 500 shares of XYZ at $90. You sold 150 at $95. You made $750 on that one trade. You still own a lot more that have incurred profits as well. You just haven’t sold them yet. Then, you sold another 100 shares at $105 making 15 points on each. That gives you another $1,500. Now, you are still holding 250 shares of XYZ stock at $90. If you bought 250 shares at $90 and now XYZ is at $105, you have $3,750 in an open position profit. This adds up to $6,000 on the stock side of the straddle. Let’s take a look at the put side of the trade. You bought the puts for $2.75, which translates to $2,750. They are worth only $1,625 now, which means you have lost $1,125. That creates a net profit of $4,875—a pretty healthy profit.

Adjustment Example

Since a large trade ratio allows us to make even more adjustments, let’s try a 10 × 20 long synthetic straddle. On March 25, using XYZ trading at 30, we initiate the following trade: short 1,000 shares of XYZ at $30 and long 20 June XYZ 30 calls at $3.50. Each call option costs $350 (3.50 × 100) for a total debit of $7,000 (350 × 20). Four days later, the market moves to $35. The calls are now worth $11.25 each and are now one strike in-the-money. This means that the 20 long calls now have a total delta of +1,300, creating an overall position delta of +300. To return to delta neutral, we make an adjustment by selling 300 more shares. We now have a position that is short 1,300 shares of XYZ and long 20 June XYZ 30 calls.

Two days later, the market rises to $40. Once again, the long deltas increase another +300. We sell 300 more shares to adjust the trade back to delta neutral. That gives us an open position of long 20 calls at $19, short 1,000 shares at $30, short 300 shares at $35, and short 300 shares at $40. Let’s take a look at the cash settlement to date. We originally sold 1,000 shares at $30, incurring a credit of $30,000. We made our first adjustment by selling 300 more shares at $35 for an additional credit of $10,500.

Then we sold 300 shares at $40 or $12,000. This creates a total credit of $52,500. However, since the price of XYZ has been increasing, we have lost the following on the shares with XYZ trading at $40. On the other side, the long calls originally cost us $3.50 each for a total debit of $7,000. They have increased in value to $19 or $1,900 each, for a total of $38,000. This creates a profit on the call side of $31,000. If we reconcile this with our loss on the stock side, we have total profit of $19,500 ($31,000 – $11,500 = $19,500).

ADDITIONAL ISSUES

Can you make adjustments on 1 × 2 trades? Approximately 90 percent of the time, a 1 × 2 trader will not make any adjustments. The trade is simply placed and exited when the market moves. If an adjustment is possible, it will most likely be made on the option side. Frequently, when the market moves up fast and you see a dramatic increase in volatility, it can be better to get out of the trade altogether. Why? Because when you have an increase in the volatility, the premium on an option is going to pump up. I recommend exiting the trade, waiting for volatility to collapse a little, and then getting back in. 

For example, if you have a 1 × 2 (100 shares × 2 options) or 2 × 4 (200 shares × 4 options) trade, you have to have some decent-sized market movement, and a good profit (i.e., 20 percent), before you even consider making an adjustment. Why make an adjustment at all when you can just get out of the trade and then get back into the trade when the market calms down? If you can make a 20 percent return on your risk capital, you are on your way to healthy, consistent profits. What determines whether you initially go short or long the underlying stock with the corresponding long two puts or long two calls? The way to decide is to look at the prices of the puts and calls and buy the ATM options that are the cheapest. 

You could be looking at a computer or you could be looking at the newspaper at the end of the night. Let’s say XYZ shares are trading at $48 and the 50 puts are $3.25. There is a $0.75 difference between the price of the puts and the price of the calls. Therefore, I would rather pay $2.50 for the calls and buy two for each I sell. But it really doesn’t matter which way you go to get to delta neutral. It is safe to assume that you want to take the less expensive of the two options and thereby pay less money out-of-pocket. Taking less money out of your account initially is a good technique to use if you want to dramatically increase your account size. That’s where the real buried treasure lies, and it’s just waiting for you to discover it.

USING ADJUSTMENTS TO REPAIR A TRADE

The type of strategies that traders implement is a major factor that determines their success or failure in this business; however, the ability to adjust positions to obtain maximum profitability is what separates the professionals from the average trader. There have been situations where I have made changes to a position and then within in a couple of days realized that I had made the wrong decision. When you are faced with these types of circumstances, it is important to be able to think outside of the box in order to create a new position or fix the mistake that you made. Let’s review how to fix a trade when mistakes have been made and where revisions will improve the risk/reward profile. 

Let’s use an example of a long synthetic straddle using Nortel Systems (NT). My original assumption in 2000 was that NT was consolidating to go higher, so the trade was placed in anticipation of making a profit from the increase but was hedged just in case things went differently. The original trade was composed of going long 1,000 shares of NT at $81.50 and long 20 January 85 puts at $11. This long synthetic straddle was pretty close to delta neutral with an overall position delta of +50. Unfortunately, the market assumptions on NT were completely wrong. In addition, some mistakes were made when adjusting this trade that turned this relatively good trade into somewhat of a problem—the cause of great frustration.

A couple days after putting this position on, NT began to fall and it started to fall hard. After the third day of the stock falling, it closed above its low from the day before. This seemed like a reversal and since the shares seemed headed to go higher from that point, I reacted by selling off five of my puts and taking some profits. At that point in time, this seemed like a great idea, because I was booking some profits, increasing the delta of my position, and setting myself up for the big run-up the shares were going to make. Unfortunately, the shares continued to fall and fall and fall! What a terrible decision it was to sell off part of my protection (the puts); but it wasn’t a complete disaster. 


FIGURE  NT Price and Volume Chart


FIGURE  Original NT Risk Profile


I was still long 15 puts against the long 1,000 shares; however, it would have been much more profitable to have held on to the puts that I sold. This left me just about breakeven in a trade that could have been far more profitable. I simply didn’t feel comfortable with the risk profile anymore. The shares would have to continue lower or really ramp in order for this trade to turn green for me. Even though the options didn’t expire until January, I was still fighting with the issue of time decay. In reality, the shares could remain range-bound for a while. It was time to consider my alternatives. I could exit the whole trade and continue to remain angry for making a costly mistake, or I could think creatively and change the whole profile of my original position.

I opted to do the latter. My longer-term assumptions for this security had not changed. I still thought the shares would eventually go higher. Let’s take inventory and see what we have to work with. We have 1,000 shares of stock and 15 puts. The problem is that if the shares remain in a range from this point, I will lose the time value that I paid for in the options. There are a number of different changes that can be made to this position; but I prefer to turn the synthetic straddle into a collar. This is accomplished by purchasing 500 more shares of stock at $60 and selling 15 January 90 calls at $1.50. 


FIGURE  NT Risk Profile after Selling Five Puts

These adjustments decrease the maximum risk on the entire trade and relieve my mind of the time decay problem. Additionally, I still have a nice profit potential if the shares do head higher. The maximum risk on this trade has been reduced to $2,000. The maximum reward is approximately $20,000, which is realized if the shares climb to the mid 90s by January expiration. As you can see, this position begins to react immediately if the shares begin to climb; and even if I’m wrong again and the stock heads south, I am limited to a small loss at January expiration. 


FIGURE  NT Risk Profile of Collar Position

If the stock does not move in my favor within the time frame needed, then I can readjust the positions and give myself more time to be right. The process of adjusting positions is just as much an art as it is a science. There are usually many different courses of action that you can take. Sometimes you will be right on the first try. Other times you will be wrong or maybe your market assumptions change while being in a trade, requiring you to change the profile of the position. The key to successful trading is to be able to creatively make changes that enable you to obtain a risk profile that makes you feel comfortable.

911 STRATEGIES

Here’s a dose of reality to those who are reading this book! You can have the best trading system in the world that works 90 percent of the time, with low drawdowns and big gains; but if you don’t have an exit plan or an adjustment plan when things don’t go your way, that great system isn’t going to help you at all. Optionetics 911 strategies are designed to teach you various techniques that focus on teaching you how to fix losing positions. Seminar students frequently ask, “Is there any possible way to fix a losing stock or option trade?” Rest assured that our Optionetics team of traders has found some viable answers. However, I want to first point out a mistake made by many traders—a mistake I used to make myself until I gained some other tools that work in these types of situations. 

We’ve all taken directional stock trades in which the particular stock has gone 5 to10 points against us. Many traders assume that the only way to fix a losing position is to average up or down, depending on the directional bias of the initial trade. Averaging down is put into practice by purchasing more of a stock at a lower price in order to reduce the average cost per share. Averaging up consists of selling more shares at a higher price. These types of approaches not only require more capital, but also increases the risk of the trade. For example, if you were to buy 100 shares of XYZ at $100, the cost of the trade would be $10,000. If XYZ stock fell to $90, the trade would have an open position loss of $1,000. Buying 100 more shares of XYZ at $90 would require another $9,000. 

Although it lowers the breakeven on the trade to 95, you have doubled your risk if the stock continues to decline. This is a very dangerous strategy in some cases, especially when markets are in a free-fall. Many traders have used this strategy only to find that they regretted averaging down later. Just imagine if you had done this with an Internet stock that was trading at $420 per share and now trades at $5. Some traders may choose to buy an at-the-money (ATM) call on XYZ. This approach ties up less capital, reduces the breakeven to 95, and is less risky than averaging down on the stock. However, this solution still requires additional trading capital for the cost of the option. If XYZ were to stay at 90 or below, the option expires worthless, meaning you lose the additional money paid to purchase the option. 

This is a more sophisticated approach but also has its perils. Let’s say you get a hot tip on a stock, and you decide to position yourself for a big gain if the stock moves up. You place the order and wait, and wait, and wait! The stock does nothing. You may think the option is going to do nothing as well, but unfortunately the option loses value while you’re just sitting there like a deer in the headlights. The options drop to half their original value and you’re stuck wondering why you got into this position in the first place. But there are ways to repair this position. Learning what they are, and how they are applied is the key to reducing your losses and increasing your returns.

Our Optionetics team has researched and discovered many ways to fix long and short positions, as well as spread positions on stock, options, and futures. Each Optionetics 911 strategy fulfills three basic criteria that make up a good trade by:

1. Reducing the breakeven of the position.
2. Tying up no additional capital.
3. Allowing the trade to still have profit potential without any additional risk.

CONCLUSION

When I see people, including my colleagues, who make their living by navigating the markets, I feel very fortunate that options play such an integral role in my trading process. The simple reason is that options are the most flexible financial instruments that exist in the markets today. They provide unique investment opportunities and advantages to the knowledgeable trader on a regular basis. Yes, the entire options arena can be a very complex and confusing place to venture—especially for the novice trader—but the rewards far outweigh the sacrifices of getting there. One of those rewards is that you never have to be stagnant. There is always something that you can do to make the risk/reward characteristics of your trade fit your objectives. Remember Legos, those building toys you used to play with as a kid? Well, options are very similar; they let you build to your heart’s content.

As we all know, this market can be one tough cookie to beat. Sometimes the best approaches have been nondirectional in nature. Add the critical levels we’re currently trading to this difficult environment and you have a recipe for some serious fireworks, one way or the other. I’m a big believer in protecting profits by making adjustments. This is where the major dilemma comes in and where the flexibility of options provides us with many advantages over other techniques. When taking profits, the major emotion that we have to deal with is greed. Have you ever caught yourself thinking, “Well, I’m just going to capture those last couple of points I’m entitled to on my bull call spread”? I used to think this way all the time—until that time the stock came crashing down and my profits faded away in the blink of an eye.

There are a couple of ways to protect yourself from this scenario. First, if you’ve already doubled your money in the trade, it may make sense to take half of the position off for a no-risk trade. It may also make sense to take the entire position off and make 100 percent! This is a great situation to be in, but not one in which we always find ourselves. For example, positions that are constructed with LEAPS take more time to mature (depending on the type of trade). Therefore, you may not have doubled your money, even though the security has moved big in your direction. Let’s say you’re up 15 percent in your trade, but it will be quite some time before the profits really kick in. You don’t want to exit the entire trade because your profit potential is much higher; but at the same time, you don’t want to give up the gains you’ve already earned. 

What can you do? When I’m in this situation, I adjust the position so that I keep my original upside and protect my profits on the downside or even make money on the downside. One way to achieve this is to simply purchase puts against the position. You want to minimize the time value you pay for these puts, so going in-the-money is a good idea. The number of contracts that you would purchase is subjective and dependent on the risk profile you want. The best thing to do is look at a number of different alternatives by checking out what the Optionetics.com Platinum site has to say. The objective here is to protect the profits you’ve already made and not take the upside (or downside) out of your position. 

If you adjust the trade correctly, you lock in profits, keep upside reward potential, and have the ability to make money on the downside. Talk about a stress reliever! Incorporating these types of adjustment strategies into your trading approach is vital to your success as a trader. The more contracts you have to buy and sell (i.e., 2 × 3, 3 × 5, 5 × 10), the more profitable adjustments you can make. It’s somewhat like being in Atlantic City or at the racetrack. If you are betting on a horse with 2-to-1 odds, you know you have a pretty decent chance of winning. If you bet on a horse that has 100-to-1 odds, your chances of winning are slim, but the payoff would be enormous. Consistent returns on your investments lead to the gradual accumulation of wealth.

The accounts I trade have increased dramatically over the years because I take profits on a consistent basis. You, too, will be able to increase your account size dramatically. Did you ever lose everything you had in the futures or stock market? I have, more than once. But I persevered in the face of what seemed impossible odds and bounced back into prosperity. It can happen to anybody. With delta neutral trading, you have a much better chance of succeeding. I tell a lot of traders that if they cannot trade delta neutral, then it’s better not to trade at all. I believe that trading without visualizing the risk and subsequently limiting that risk is akin to gambling at a Las Vegas craps table—the house eventually wins.

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