The fundamental aim of most adjustments in options trading is to reduce directional exposure. Therefore, the underpinning of most adjustments is delta hedging, which helps manage risk by balancing positions to lessen the impact of price movements. We will highlight several different adjustments for various strategies and scenarios. Keep in mind that every situation is unique, making it difficult to specify details such as timing, cost, and size, etc.
Delta Hedging
Concept: Delta hedging reduces risk and directional exposure by entering a counter-trade to your original position.
Execution 1: For example, if the market threatens your Call Credit Spread (CCS), you can buy a long call to offset the risk/losses. This may increase your capital requirements and your risk.
Execution 2: Alternatively, you can sell a Put Credit Spread (PCS) to collect more premium and offset the risk/losses from the Call Credit Spread (CCS). This approach reduces your risk without increasing capital requirements (essentially entering an Iron Condor).
Note: Don’t overthink it! Complex calculations are unnecessary; the Greeks change too quickly. Focus on reducing directional exposure according to the situation and manage as per your process.
Put Credit Spread (PCS) - Roll Down or Down and Out (Defensive)
Thesis: The underlying thesis remains valid, but the timing is off.
Market Behavior: Markets often trend for weeks, usually in an upward direction, making this roll attractive when the trend is positive.
Execution: Ideally, roll at a credit; however, once the price breaks your short strike, the credit will turn into a debit.
Timeframe: You can roll to the next day or possibly weeks out.
Risk:
Rolling for Credit: Reduces risk
Rolling for Debit: Increases risk
Rolling Out: Increases time
Call Credit Spread (CCS) - Roll Up or Up and Out (Defensive)
Thesis: The underlying thesis remains valid, but the timing is off.
Market Behavior: Markets generally trend for weeks, up more often than down, making rolling a Call Credit Spread (CCS) less effective than a Put Credit Spread (PCS).
Execution: Ideally, roll at a credit; however, once the price breaks your short strike, the credit will turn into a debit.
Timeframe: You can roll to the next day or possibly weeks out.
Risk:
Rolling for Credit: Reduces risk
Rolling for Debit: Increases risk
Rolling Out: Increases time
Pull the Short Strike (Offensive)
Thesis: The underlying thesis has been invalidated, potentially due to a catalyst that sparks a directional move and shifts market sentiment.
Execution: Pulling the short strike realizes a loss, moving the breakeven point further away but uncapping profit potential.
Adjustment: You can further modify the structure by adding to your long strike, which reduces the breakeven point and increases ROI.
Iron Condor Consideration: If you are in an Iron Condor position, you may need to pull the short strike on both the call and put side, as capital requirements may increase significantly.
Risk: You may incur losses on both the short strike and the long strike if the market moves against your position.
Leave the Short Strike and Add to Long Strike (Offensive)
Thesis: The underlying thesis has been invalidated, either in the short term or indefinitely.
Execution: Instead of pulling the short strike, which locks in a loss, you can add to your long strike. This approach essentially enters a long ratio trade (Example: long 2, short 1), providing more directional exposure.
Risk: While this strategy increases risk, it also increases ROI potential.
Reverse Conversion (Offensive)
Thesis: The underlying thesis has been invalidated and price breaks through both the short and long strike of your spread.
Execution: For example, if you sold a Put Credit Spread (PCS) at 5700/5695 and the price breaks through 5695, you can sell a Call Credit Spread (CCS) at or above 5695. The goal is to collect enough credit to offset or exceed the loss on the Put Credit Spread (PCS).
Future Opportunities: This provides the opportunity to sell another Put Credit Spread (PCS) later, allowing you to collect more premium, thereby reducing risk while keeping capital requirements unchanged.
Risk: This strategy increases capital requirements but reduces or changes directional exposure.
Butterfly Conversion (Offensive/Defensive)
Thesis: The underlying thesis has shifted from the market holding at a certain level to potentially pinning at that zone.
Execution: Sell another short option and buy the other long strike equidistant from the short options.
Risk: This adjustment can tilt the risk/reward in your favor.
Adjustment: You can make this conversion temporarily to cap losses and unwind if you believe the market will close below your short strike.
Note: This adjustment is difficult with 5-wide credit spreads and is best applied to 10-wide spreads or greater.
Protective Overlay (Iron Condor-Specific)
Thesis: The underlying thesis may not be invalidated, but one side of the spread is threatened.
Execution: For example, if the market moves lower, resulting in a loss on your Put Credit Spread (PCS) while the profit on the Call Credit Spread (CCS) is insufficient to cover that loss, you can sell another Iron Condor around your threatened spread (in this case, the Put Credit Spread).
Risk: This strategy reduces risk but increases capital requirements.
Delta Balance (Iron Condor-Specific)
Thesis: The underlying thesis may not be invalidated, but one side of the spread is threatened.
Execution: Add contracts to the unthreatened side to collect more premium and offset losses on the threatened side.
Risk: This adjustment reduces risk by creating a more delta-neutral position but increases capital requirements.
Adjustment: If the market then moves in the opposite direction, you may want to add to the other side to maintain delta neutral.
Move Profitable Strike In (Iron Condor-Specific)
Thesis: The underlying thesis may not be invalidated, but one side of the spread is threatened.
Execution: If one side of the spread is near worthlessness, close the trade and resell it closer to-the-money to collect more premium.
Risk: This adjustment reduces risk and directional exposure.
Pull the Short Strike(s) of the Butterfly (Long Butterfly-Specific)
Thesis: The underlying thesis of pinning a specific strike has diminished greatly, and the focus is now on exiting the trade for a profit.
Execution: If your spread is nearly worthless, you can close the short strikes, resulting in a position of two long options with different strikes.
Risk: This increases risk (due to the increased debit) but increases ROI potential and increases the probability of closing the trade for a profit, as the short options will no longer offset gains from the long options.
Overall, there are minimal adjustments that make sense for a long butterfly spread due to its low-risk, high-reward nature. It's generally best to leave it alone and let it work. The last hour of trading tends to be the most volatile, and a nearly worthless spread can quickly turn profitable during this time.
Quick Reference Table
What does Conner do?
Most of the time, my credit spreads don't require adjustments, but there are exceptions. My primary strategy is delta hedging using long calls or long puts, with the primary goal of reducing directional exposure to some extent. Here are some tips:
Stay Within Your Credit: Avoid spending more than the credit received from the spread. If you do, ensure you have strong conviction in your position, as you're increasing your directional exposure and altering your risk profile.
Early-Day Strategy: If it’s early in the trading day, consider purchasing options that are further out-of-the-money. This approach can help lower costs while increasing leverage.
Late-Day Strategy: If it's later in the day, opt for options that are close to-the-money, as they typically won't be too expensive given the time remaining and can gain value very quickly.
Full Protection: For full protection against a max loss on the credit spread, purchase options below your short strike for a Call Credit Spread (CCS) and above your short strike for a Put Credit Spread (PCS). Keep in mind your breakeven points.
Critical Levels: I generally implement this hedge when a significant level is breached, whether it’s my short strike or a key support/resistance level I’m monitoring.
Fine-Tuning Management: Long options can lose value quickly if the market moves against you, so don’t hesitate to scale in and out of these hedges.
Profit Booking and Loss Mitigation: If my hedge profit has exceeded the maximum loss scenario on the credit spread, I typically book profits and refrain from re-entering. Instead, I focus on minimizing the loss on the credit spread by closing the trade at a more favorable price.
Risk Control: You never know when a trade might turn south, so it's essential to be prepared with a plan and have capital ready to deploy. It's most important that you do not exceed your risk parameters. If an adjustment would push you beyond those limits, it’s best to use a stop loss. Remember, adjustments can increase risk.