Hold, Fold, or Adjust?
There are good reasons for adjusting any position that has been losing money or otherwise not working as planned.
The philosophy of adjusting positions
There is a common misconception that the purpose of making an adjustment is to prevent a loss. In other words, when a trade is losing money, the trader "does something" -- almost anything -- in an effort to recover the loss and come out of the trade with a profit.
That way of thinking is harmful because the trader:
The correct mindset
Future earnings vs. recovered losses
It is wise and efficient to exit a poor position and use your cash to buy a better position -- one that has a better chance of increasing the value of your account from the time that the position was adjusted into the future
This may seem to be a trivial difference, but it is important because it affects the quality (and therefore the profitability) of your positions.
All money spends the same. Consider this: If your last trade lost $1,000, your portfolio will be worth the same sum regardless of whether you earn $1,000 from a new position or hold onto the losing position and recover $1,000.
So what is the difference? The probability of earning that $1,000 (or any other sum) is significantly better when you open a new trade that meets all your requirements for a new position: Why hold onto a position that remains uncomfortable to own -- even after it has been modified?
When you adjust a position with the goal of getting back to even on the trade, You have fewer good choices and traders often accept the risk of owning those poor positions -- just because it gives them the possibility of coming out ahead. Ignored is the fact that the more likely outcome is the loss of additional money.
Example
You sold the following credit spread on July 10 when XYZ was $102 per share. The spread premium was $1.00 (i.e., you collected a total of $800 for the 8-lot). Today (July 22) the stock is trading at $114, and it would cost $2.20 to exit. That represents a loss of 8 * $120, or $960.
Buy 8 XYZ Aug 120 calls
Sell 8 XYZ Aug 115 calls
Premium $1.00; cash collected: $800
Although your universe of possible trades is large, let's assume that you have two choices:
Buy 13 XYZ Sep 125 calls
Sell 13 XYZ Sep 120 calls
Premium: $1.40; cash collected: $1,820
Why 13-lots? To collect more than the $1,760 paid to cover the original position, it was necessary to sell 13-lots. [NOTE: IT is not necessary to collect cash for the adjustment, but the break-even trader prefers to collect more cash every time a trade is made.]
The good news
To the trader looking to recover the loss, this spread provides that chance. It cost $1,760 to cover and he/she collected more than that amount when rolling the position to September. If The XYZ Sep 120 calls expire worthless in ~9 weeks, then the "whole" trade would be profitable. Not only would the trader keep the original $800 premium, but would also earn an additional $60 from the roll (enough to cover commissions). The rationale for collecting cash is simple: When one of these trades finally works, he/she will have the desired profit. The possibility of destroying an account while waiting for that profit to materialize is never considered]
In addition, this position probably feels 'safer' to hold because imminent risk was reduced. In other words, the likelihood of the short option immediately moving into the money is less.
The bad news
Risk increased. That is poor risk management and not a smart thing to do when the primary purpose of adjusting a position is to reduce risk. The maximum possible loss for the original position was $3,200 ($400 * 8). By increasing position size, the maximum loss is now higher. It is $360 * 13 [max value for the spread is $5.00, minus the $1.40 already collected] for the post-adjustment position, minus the $60 cash collected for rolling. Total cash at risk is now $4,620.
The position may feel safer to own, but that is an illusion. The only part of the trade that is "safer" is that the chances of seeing the spread move into the money today are less. The stock has been rising steadily and the new position does not expire for an extra 4-weeks. There is nothing safe about that.
The worst news of all is that the trader not only has additional risk, but owns a position that he/she does not truly want to own. Notice that the original trade involved selling a spread for which the short option was 13 points out of the money ($115 - $102) and the new position is not only larger, but the options are only 6-points out of the money. Those positions represent very different risk parameters and are almost certainly too uncomfortable for this trader.
Conclusion
We all make our individual trade decisions and decide how much risk we want to accept for any trade. However, the trader who insists on trying to salvage every trade will make very poor decisions at adjustment time. In this example, the need to break even resulted in selling 62% more spreads and the position is closer to being in the money that this trader's usual position All in all, a bad (risky) position to own that was made for no good reason -- other than an attempt to avoid taking a loss. That is not how adjustments should be made.
The philosophy of adjusting positions
There is a common misconception that the purpose of making an adjustment is to prevent a loss. In other words, when a trade is losing money, the trader "does something" -- almost anything -- in an effort to recover the loss and come out of the trade with a profit.
That way of thinking is harmful because the trader:
- Loses discipline and develops the bad habit of stubbornly refusing to accept the truth: The trade lost money.
- Fails to exit positions that have become too risky to hold. In other words, the position is held with the hope that the stock market will deliver a miracle. Hope is not a strategy.
- Often takes action that increases risk -- all in an attempt to recover lost money.
The correct mindset
Primary reasons to adjust
To protect the assets in your account.
To reduce future losses.
To turn the current position into one that is comfortable to own. The post-adjustment position is good enough that you would consider initiating that adjusted position as a brand-new trade.
Secondary reason to adjust
To generate future earnings. It is not made to recover lost money. The difference is subtle but important (see below).
Never adjust to avoid taking a loss
Future earnings vs. recovered losses
It is wise and efficient to exit a poor position and use your cash to buy a better position -- one that has a better chance of increasing the value of your account from the time that the position was adjusted into the future
This may seem to be a trivial difference, but it is important because it affects the quality (and therefore the profitability) of your positions.
All money spends the same. Consider this: If your last trade lost $1,000, your portfolio will be worth the same sum regardless of whether you earn $1,000 from a new position or hold onto the losing position and recover $1,000.
So what is the difference? The probability of earning that $1,000 (or any other sum) is significantly better when you open a new trade that meets all your requirements for a new position: Why hold onto a position that remains uncomfortable to own -- even after it has been modified?
When you adjust a position with the goal of getting back to even on the trade, You have fewer good choices and traders often accept the risk of owning those poor positions -- just because it gives them the possibility of coming out ahead. Ignored is the fact that the more likely outcome is the loss of additional money.
Example
You sold the following credit spread on July 10 when XYZ was $102 per share. The spread premium was $1.00 (i.e., you collected a total of $800 for the 8-lot). Today (July 22) the stock is trading at $114, and it would cost $2.20 to exit. That represents a loss of 8 * $120, or $960.
Buy 8 XYZ Aug 120 calls
Sell 8 XYZ Aug 115 calls
Premium $1.00; cash collected: $800
Although your universe of possible trades is large, let's assume that you have two choices:
- This stock is acting too bullish and (fearing additional losses), you decide to exit. The loss is $960 plus commissions. Your plan is to initiate a new spread (8-lots @ $1.00) in a different stock (one that you have been watching carefully and believe that this is a good time to open a credit spread). If that trade works well, your expected gain is $800. This is a good position, even though it cannot earn enough to recover the entire $960 loss.
- You decide to adjust -- with your objective being to get back to even -- by "rolling the position down and out." The trade involves two parts. First, buy 8-lots of the XYZ Aug 115/120 call spread, paying $1,760. Immediately thereafter move the XYZ position to a more distant expiration (rolling out) and to higher strike prices (rolling down) :
Buy 13 XYZ Sep 125 calls
Sell 13 XYZ Sep 120 calls
Premium: $1.40; cash collected: $1,820
Why 13-lots? To collect more than the $1,760 paid to cover the original position, it was necessary to sell 13-lots. [NOTE: IT is not necessary to collect cash for the adjustment, but the break-even trader prefers to collect more cash every time a trade is made.]
The good news
To the trader looking to recover the loss, this spread provides that chance. It cost $1,760 to cover and he/she collected more than that amount when rolling the position to September. If The XYZ Sep 120 calls expire worthless in ~9 weeks, then the "whole" trade would be profitable. Not only would the trader keep the original $800 premium, but would also earn an additional $60 from the roll (enough to cover commissions). The rationale for collecting cash is simple: When one of these trades finally works, he/she will have the desired profit. The possibility of destroying an account while waiting for that profit to materialize is never considered]
In addition, this position probably feels 'safer' to hold because imminent risk was reduced. In other words, the likelihood of the short option immediately moving into the money is less.
The bad news
Risk increased. That is poor risk management and not a smart thing to do when the primary purpose of adjusting a position is to reduce risk. The maximum possible loss for the original position was $3,200 ($400 * 8). By increasing position size, the maximum loss is now higher. It is $360 * 13 [max value for the spread is $5.00, minus the $1.40 already collected] for the post-adjustment position, minus the $60 cash collected for rolling. Total cash at risk is now $4,620.
The position may feel safer to own, but that is an illusion. The only part of the trade that is "safer" is that the chances of seeing the spread move into the money today are less. The stock has been rising steadily and the new position does not expire for an extra 4-weeks. There is nothing safe about that.
The worst news of all is that the trader not only has additional risk, but owns a position that he/she does not truly want to own. Notice that the original trade involved selling a spread for which the short option was 13 points out of the money ($115 - $102) and the new position is not only larger, but the options are only 6-points out of the money. Those positions represent very different risk parameters and are almost certainly too uncomfortable for this trader.
Conclusion
We all make our individual trade decisions and decide how much risk we want to accept for any trade. However, the trader who insists on trying to salvage every trade will make very poor decisions at adjustment time. In this example, the need to break even resulted in selling 62% more spreads and the position is closer to being in the money that this trader's usual position All in all, a bad (risky) position to own that was made for no good reason -- other than an attempt to avoid taking a loss. That is not how adjustments should be made.
Source...