Track That Trade: 110602

Looking for a trade that will require adjustments because those adjustments are something we want to discuss in greater detail.
NOTE: July 8, 2011. In response to requests to follow more trades to their conclusion, I’m updating this trade

July 18. Trade closed with a nice profit.

Jun 2, 2011. The Trade

Sold 24 delta options.
NOTE THIS IS NOT A RECOMMENDED TRADE. This trade was made with the intention of running into trouble and being forced to make an adjustment.

Please do not make this trade for your own accounts.

NOTE: With a 48% probability (add delta of options sold) of one option finishing ITM, this trade is too CTM (close to the money) for my personal comfort zone. However, for some traders, this is a normal, everyday type of trade. The following discussion is not about the merits of the trade. It’s about managing risk.

8:45 am CT; Rut ~822
Sold RUT AUG 750/760 P spread 10 x, collecting $1.90 per spread (midpoint was $2.10)
Sold RUT AUG 880/890 C spread 10 x, collecting $2.30 (midpoint $2.50)

Orange arrows point to option delta. Note this image was made 3 hours after the trade.
Black arrows point to the bid/ask market for each of the credit spreads in the iron condor.

More detail on the individual options, including the greeks

The dotted line represents P/L for given RUT prices on Aug 19, 2011 (the date on which the settlement price is calculated).

Adjustment: Jun 3, 2011

We had the move we hoped to see. It occurred immediately with an unfavorable employment report.

I did two things very different this time:

    a) Made the adjustment earlier than I would usally make it. The delta of the short option was ~30 and it was still 50 points OTM

    b) I chose a very different type of adjustment for discussion.
    This adjustment type is for special situations. It is not suggested that you make use of it under ordinary circumstances.
    But it is a tool that you may want in your arsenal. Especially for anyone who fears a huge market collapse.

    Here is the trade, with charts. Discussion coming later. Please do not copy this trade before (or even after) having a thorough understanding of what is involved.

    Bought 6 RUT Sep 720 P
    Sold 4 RUT Aug 760 P (Yes, sold more of the option we are short)

    More discussion coming. It’s very important. This trade has many features that provide educational opportunities.

    I know that some readers will find this trade to be completely unacceptable, while others will like certain features. I must stress that this trade was selected so allow for certain important ideas to be the subject of a full discussion. This trade is NOT recommended. You may want to do something similar in the future, but please – not yet.

    Discussing the adjustment

    June 6, 2011

    Update July 8, 2011

    The recent rally has made the upside uncomfortable. As I prepare to update this trade, the pre-market says that the unemployment numbers were not good enough and the market appears to be opening lower. Nevertheless, let’s take a look at this position at wherever it opens this morning.

    Risk graph as of last night’s close:

    as of close, July 7, 2011

    Risk graph shortly after the market opens July 8, 2011.

    IC as the market opens

    110708. Three minutes after the market opens. RUT now 847

    New adjustment type

    In an effort to broaden our horizons, I’ve chosen a different type of trade as an adjustment.

    Please note: This adjustment costs substantial cash and thus is one that many traders would eliminate from consideration. It also offers limited protection, another negative. More than that, if the market continues its move higher, that limited protection can turn into a negative. In other words, instead of helping reduce losses, it can add to losses. Fortunately, there is a way to prevent those extra losses. However, taking a small profit from an adjustment trade defeats the major purpose – which is to prevent large losses from the initial position.

    With all those negative features, is this truly a trade adjustment that is worth considering? Let’s take a look. Please do not even consider making this trade for your own account unless you find the benefits are sufficient to outweigh the negatives.

    The Trade

    Buy 4 RUT Sep 900 calls
    Sell 4 RUT Aug 900 calls
    Debit: $520 per calendar; $2,080 total.

    The trade is the purchase of an OTM call calendar spread which makes money on a rally. The September call option has a higher delta than the August, and as a result, the position is delta long.

    calendar added

    Adjusted by adding 4-lots of the Sep/Aug 900 call spread

    If you are familiar with calendar spreads (we did have a short discussion when following trade: 110629 plus there is a five-part blog post dedicated to the calendar spread at Options for Rookies), then you know that profits are limited – and can disappear when the underlying asset moves beyond the strike of the calendar.

    Gains are limited because the Aug calls will have a larger gamma than the Sep calls – when the stock gets nearer to the strike.[The spread gamma is essentially zero now.] In other words, Aug call delta rises more quickly than the Sep call delta. As RUT moves past 900, the Aug 900 C delta becomes the larger delta.

    The solution to this specific problem (losing money past 900) is to sell the call spread when RUT is near 900. Of course, we would no longer be holding the 880/890 C spread at that point. It would be way too far ITM and we would be well on out way to losing the maximum possible amount for this position. Thus, if another adjustment is needed, it will probably make sense to unload this call spread at the same time.

    So why make this trade? Admittedly it is not for everyone. Because if can add to profits in a significant way. For example, consider the situation in which time passes, RUT rises by a small amount and you exit the trade. The graph below represents the hypothetical situation:

    30 days later

    Calendar spread; 30 days ;later

    The $1,000 profit from the calendar provides a cushion for holding the original trade. If (big if) you want to hold into expiration month, the calendar provides a small cushion against losses from a rising RUT. If you are an undisciplined trader who is looking for any excuse to hold onto a losing trade for a longer period of time, this specific type of adjustment will add to that lack of discipline. Thus, be careful if adopting it.

    One alternative that makes the trade bit more attractive is to choose lower strike prices for the call spread. Buying the Sep/Aug 880 spread is most profitable at the point when the iron condor trade gets into serious trouble – when RUT = 880.

    Buying the Sep/Aug 890 call spread converts the call credit spread into a diagonal spread. I would choose this play only when you truly want to be long vega. Be warned that this is not generally a good idea when our risk is to the upside (but would work better with downside risk). The chances are good that a rising market would see a drop in IV, and that’s not good when the trader is long vega.

    This calendar spread works for traders who want to make a specific play. It’s a viable idea if you want to predict, and wager on, the idea that the market will drift higher but that the original call spread will not become a bigger problem. If time passes with no further rally, the call 880/890 spread can be closed at a reasonable price (small profit to small loss; or even a good profit if enough time passes), and at the same time, the passage of time will not hurt the calendar spread. It’s final value (final because there is no reason to own if once the credit spread has been closed) will be totally dependent on then current IV levels.

    The OTM calendar spread has limited appeal when it is made as an adjustment late in the game (as we are doing now). However, this play work better if the trade is made as an early adjustment. True, the gains are still limited, but the cost is significantly less – and that makes the trade more attractive.

    Limited gains

    As is always the case, when we add an adjustment that has limited gains, the original position is not fully protected. However, let’s keep in mind that we never really want to ‘fully protect’ the original. That’s just too costly. We want to add some protection against loss because there must be a point at which the original trade is no longer worth holding.

    Adjustments that include ownership of naked long options still offer ultimate protection when the underlying makes a giant move. But those moves are rare, and most of the time it turns out that spending too much money to buy those naked options leads to unhappy results.

    I feel that it is important to emphasize the decision concerning how m uch to pay for an adjustment:

    • When it comes time to make an adjustment trade, the idea is to prevent further losses
    • The idea is not to make a trade that gives you the best chance to recover past losses
    • If you can accomplish both of the above, that’s good. However, emphasis should be placed on the future, not the past. Preventing further losses is the primary concern
    • You do not have to make a new trade as an adjustment
    • Exiting the trade is a perfectly good adjustment alternative
    • I often say that a trader should not limit the cash spent on an adjustment to some arbitrary number
    • But do not believe that you can buy options, spending an unlimited sum is a good idea.
    • Always consider the risk of seeing the market turn around after the adjustment is made
    • If that turn around comes, you cannot afford to get burned on the other half of the iron condor. Thus, give serious consideration to entering a bid to repurchasing the put spread. Don’t just pay any price. If it is not a price you are willing to pay, then so be it. But be aware that spending $2,000, as per this example, makes the downside even worse. Spending a few hundred to remove downside risk may be worth the peace of mind.

    Bottom line: Buying OTM call spreads is an adjustment method that I have never used in y own trading. The rationale for presenting this idea is that someone I know gets very good results from this method. However, I don’t know the details of his methodology and am offering this as just one more idea for consideration.

    If the market moves higher, the plan calls for exiting the calendar spread and fining an alternate adjustment for the call spread. My gut instinct is the the most appealing adjustment will be to exit, with the possibility of rolling to higher strike prices and paying a cash debit to do that.

    Update July 12, 2011


    Made a trade to protect the upside and RUT promptly declines 20 points in a single day.

    This situation is going to occur. More than once. It it upsets you, that is going to make it difficult to manage risk well. It’s sour objective to make a good decision when faced with a problem and recognize that we are not going to be ‘correct’ in our timing. From my perspective, I’d rather see the market retrace that 3% than rally another 3%.

    The decline was welcome for this position – even when we earn less than we would have earned without the adjustment.

    110712 update

    July 12, RUT = 835

    Note that RUT is 835, or about 15 points lower than when the adjustment was made. Yes the calendar spread has lost about $100 in value. That’s not trivial, but for anyone who no longer wants to hold the adjustment, a $400 loss is not so large as to be a big problem. I wold not suggest selling the spread unless you just want to take the cash now – and hope that you don’t have reason to need another upside adjustment.

    I’d rather hold.

    UPDATE and EXIT Jul 18, 2011

    It’s time to take profits and eliminate risk.
    With RUT trading near 815, the option quotes look like this:

    Time to cut risk, take the profits and exit the trade

    The iron condor is offered $ $2.38, and it is not clear how much we would have to pay to exit. But $2.30 feels about right. We collected $4.20 per iron condor when opening the trade

    The diagonal spread can be sold (we own two spreads) near $10.65. We paid $11.50 for these two spreads.

    Current risk graph

    Are we ready to exit?

    This is not an easy decision. We have positive theta, we own two extra puts, we are not exposed to an increase in implied volatility, this seems to be an ideal position to hold. However, there is a real danger zone if the market declines further – but does so slowly.

    Imagine that scenario. The market moves lower, we feel empowered by owning two extra puts, and there just never seems to be a good time to exit. If that happens, we can find ourselves in that ‘high risk zone.’ That’s the reason I suggest taking our nice profits now and avoiding the possible pain that awaits. If any of you would prefer to hold on for a few days – while being ready to jump out of the trade should those Aug 760 puts become a bigger threat, I would not argue. However, this is a case in which stubbornness can provide a bigger reward or a large loss.

    I encourage the safer lay of avoiding potential trouble.I you feel differently, please comment below.

    Trade closed.

10 Responses to “Track That Trade: 110602”

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