Adjustments can be an integral part of any option trade, but knowing when to adjust can be tricky.
Adjustments can be an integral part of any option trade, but knowing when to adjust can be tricky. Still, if you know what to look for, the market can send you a signal that the time for an option adjustment might be at hand. This doesn’t mean it’s guaranteed to be the absolute best time to adjust, but the options market can help you identify when the adjustment window is starting to close.
How do you know? Let’s start with the example of a short put. Suppose XYZ is trading at $185 and you sold an XYZ 182 put for $1 when there were three weeks until expiration. Everything was going along swimmingly until the market dropped, and now your put is worth $1.25. On paper, this is a 25 cent loss. With seven days left, you fear your trade is heading for trouble.
The natural adjustment you might consider is to roll "out and down," meaning out in time and down in strike. Rolling out in time lets you roll to a lower strike, potentially without having to pay a debit for the adjustment. Of course, the downside to this is that you’ll have to wait longer for your put to expire, but that's better than watching the trade explode as the market crumbles.
Here's a potential adjustment: Roll your 182 put by buying it to close, then selling to open the 177 put that’s two weeks further out in time. This can potentially result in a credit.
This adjustment might result in a credit because the further-out option carries more time value. But, if your 182 put gets too close to the money, then it will be worth more than the further-out option and the adjustment will trade for a debit. As long as the adjustment is available for a credit, you're probably OK. So, you can think of rolling for a credit as your escape plan.
But if XYZ continues lower and the 182 put gets closer to the money, the credit will start to shrink and move toward a debit. That’s a signal that the window for making the adjustment is closing. Another thing to keep in mind is that by the time your short put is either at or in the money, it’s likely too late to roll out and down for a credit. Keep an eye on the value of the roll so you can act before that happens.
Now assume that a few days down the road, with the market lower still, the roll has dropped to a credit of 15 cents. This might be the time to pull the trigger and roll out. Of course, if the market rallies back the next day, you'll wish you hadn't made the trade. But that's trading. It's still better than doing nothing and waking up to a put that’s now gone into the money because this can result in large losses compared to the credit.
The value of the adjustment gives you another measure of how your trade is faring. As long as the adjustment is available as a credit, things are probably okay. But as the adjustment slips toward a debit, that's a signal that your short put may be getting too close to the money, and that it might be time to make that roll.
One handy way to stay in touch with the market is by using the thinkorswim® platform to set an alert. This way you’ll be notified when your projected adjustment drops below a credit that you specify. In the MarketWatch tab, click on Alerts and use the option chain to enter the adjustment you’re considering.
The short put strategy includes a high risk of purchasing the corresponding stock at the strike price when the market price of the stock will likely be lower. Uncovered option strategies involve the highest amount of risk and are only appropriate for traders with the highest risk tolerance.
Rolling strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. You are responsible for all orders entered in your self-directed account.
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