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Fine-Tuning: Option Adjustments for Losing Trades

September 17, 2015
Option adjustments aimed at saving losing trades

Some trading lessons come fast and furious. The market isn’t always kind. Remember those option adjustments for potential winners that we introduced in part one? You’ll need a suite of option adjustments aimed at saving losing trades, too.

Got a losing trade staring you in the face? Closing the trade might be the right choice. But if the trade hasn’t yet lost a substantial portion of its risk, then making an adjustment might give you additional time for the market to do what you need, as well as reducing the overall risk.

Let’s look at two examples.

Suppose Kim, an option trader, paid $5 for the December 150 call option on XYZ stock. Now her call option is only worth $4, so it’s obviously not working out. If she loses another $1, then the trade approaches a 50% loss, and that’s her loss exit. But Kim’s analysis leads her to believe XYZ will still move higher. What kind of adjustment might she make?

Potential adjustment #1: Shift the trade into a vertical spread.

Kim might do this by selling the December 155 call as an opening trade. This adjustment changes her position into a long vertical spread, and it gives her the flexibility to stay with the trade longer because spreads typically change price more slowly than a single option.

Where does she stand on the trade? The 155 call is worth $2, so by selling that call, she’s now paid out a net debit of $3. Her position becomes the 150–155 call spread, which is currently worth $2, which also reflects her current loss of $1. Of course, to really run this math, you'd need to take transaction costs into account in each step. Those costs are a critical part of how any options trade turns out.

Review time: Let’s revisit the three key rules for adjustments. First: never make adjustments that increase the risk of your trade. Second: tailor the adjustment to match your outlook for the market. Third: treat your adjustment like it’s a brand-new trade.

Does Kim’s adjustment meet these three key rules? It reduces the overall risk and it’s still a bullish trade, but what about treating the new position like a new trade? In the previous article, we discussed designing the trade plan based on current option prices and not the original risk. If the spread value drops from $2 down to $1, then that’s a 50% loss and many traders would say it's a good time to get out. That would leave Kim with an overall loss of only $2 plus transaction costs from the original $5, which is something to consider given that not just one, but two, bullish trades didn’t work out.

Potential adjustment #2: Turning the trade into a calendar spread.

When stocks don’t move, traders turn to this adjustment to wait things out. If Kim wants to bide her time waiting for the stock to show signs of life, then selling the November 150 call turns her trade into a calendar. This reduces her net cost (and risk) to $3.50 ($5 for the original trade cost – $1.50 credit), excluding transaction costs, and potentially gives her time to let the stock do what it needs to do.

The trade adjustment you choose depends on your market outlook and trading style, and it’s wise to preview what your adjustment might look like using the tools on the Analyze tab of the thinkorswim® platform.

Of course, if XYZ finally starts to rally, then another adjustment would be needed to make this a bullish position once again. The possible adjustments are virtually limitless. Just keep the three key rules in mind, and you may soon be making more much-needed adjustments than a chiropractor.

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