Wednesday, 6 April 2016

ADJUSTING A LOSING TRADE

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RISK MANAGEMENT
When you own a directional trade that is not working (i.e., the price of your underlying asset is moving in the wrong direction or too much time has passed), eventually you must do something to mitigate risk. The basic choices are: exit the entire position, reduce the size of the position, or make a trade that reduces risk Such trades are known as adjustments.
For example, an adjustment may be necessary when you sell a put spread and the stock price falls:
Bought 5 XYZ Jul 15 '16 80 puts
Sold     5 XYZ Jul 15 '16 90 puts

The stock was $96 when the trade was made, but now (two months prior to expiration day) XYZ is $91.
It is reasonable to be nervous about the future value of this position. The position is long (i.e., Delta is positive) and getting more positive (due to negative Gamma) as the price falls. You already are losing money and that loss will increase if the stock price continues to decline. It is time (or perhaps it is already past time) to do something about risk.
In this scenario, it may seem that the best strategy is to sell call spreads (to turn the position into an iron condor) to gain negative delta. It is true that this adjustment offsets a portion of your downside risk because if the market continues to fall, the call spread will lose value and provide some gains to offset the expanding loss from the original put trade. What makes call selling so attractive is that it provides positive theta, and all premium sellers love positive theta. Also, adjusting the put side in this scenario locks in a loss -- and traders hate doing that. It feels much better to sell calls so that the trader can make money from the adjustment, even though the entire position continues to bleed and little has been done to alleviate the amount of money at risk.
However, the primary attractiveness of selling call spreads as an adjustment is that it increases the potential reward. When your trade is underwater, it is tempting to make an adjustment that has the chance not only to recover the current loss, but to add additional profits. Please, ignore that temptation. 
When a trader is already long delta because he/she is short naked puts and the stock is falling, the same principle applies. I urge that trader not to sell calls or calls spreads as an adjustment method. It is far more effective to adjust the put position because that is where risk is.
The reasoning behind this approach is that the premium that one can collect by selling call options is limited, and when the trader is naked short puts, the potential loss is unlimited. Thus, the big risk -- a sizable price decline -- is hardly reduced by selling calls.
It takes discipline and an understanding of the true risk of the position for the trader to find a winning line of play -- i.e., one that successfully reduces losses and/or turns losing traders into winners. When adjusting trades that are currently risky (i.e., not only are you already losing money on the position, but the position is like to continue losing money).
BOTTOM LINE: when you have a put position that is at risk in a falling market, take action to reduce/eliminate that risk. Be certain that your loss does not reach an unacceptable level if the stock declines further. We do that to insure our survival as traders. You never want to own a position that can place the entire account in jeopardy.
Sure, selling call spreads does generate some offsetting profits when the market declines, but those profits are almost always too small to make an impact on the loss resulting from owning a bad put position. It is far safer to exit the put spread, cover part of the put spread, or make a different type of adjustment to the put spread.

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