Adjusting a 'Trade Gone Bad'

Details: Written by Carley Garner

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Adjusting a Trade Gone Bad...and Good

by Carley Garner of DeCarley Trading

Experienced option traders are aware of the dismal probabilities involved in long option strategies. It is often said that approximately 80% of all options will expire worthless. Thus, it is fair to say that option buyers will likely lose all or some of their investment. Accordingly, option sellers are provided with arguably better odds of success. In theory, more often than not, sellers will collect but more importantly keep, the entire premium of a short option. Naturally, they must be careful not to let the few losing trades take back all previous profits plus some. Thus, due to the delicate nature of the options market it is imperative that all traders, whether buyers or sellers, have the ability to “repair” option positions in order to maximize their odds of success.

As with many aspects of trading, adjustments are not an exact science but a skill. In fact, sometimes it is even necessary to adjust your adjustment. With that said, you must realize when an adjustment is necessary and when doing so will simply add unnecessary risk or transaction costs. We have chosen two scenarios in which we would like to demonstrate option repair strategies using a bull call spread with a naked leg.

An Aggressive but Seemingly Wise Approach to Options on Futures

We are somewhat fond of a three-legged debit spread known as a bull/call or bear/put spread with a naked leg. These types of option spreads are consistent with the theory that options are priced to lose. Thus, rather than buying a close to the money option out right, traders should finance the position by collecting premium through short options. Such a strategy is relatively aggressive shouldn't be attempted by the faint of heart.

Traders that are expecting a market to rise can increase their leverage, and in my opinion the probability of a profitable trade, through the simultaneous purchase of a close-to-the-money call option and the sale of a higher strike call option as well as a "safely" positioned short put. The beauty of the trade is that you can’t lose on all three legs of the trade. In other words there is a built in diversification mechanism. Conversely, this type of spread involves unlimited risk in the form of a naked put, making it imperative that traders are prepared to adjust their stance or simply exit the trade should the market turn sharply against the position.

A three-legged spread structured in this way can, and should, be adjusted in two completely different market scenarios; the first being an attempt to “repair a trade gone bad” the other being an opportunity to “milk the trade for additional profits”.