Lesson Objective: Learning why adjusting option trades is essential and what factors to consider when adjusting.
Knowing when and how to adjust your positions is an essential part of the risk management skills that a good trader must acquire.
Timely and appropriate adjustments will help you limit your losses and may even give you enough rope to turn around a loss situation.
There is not a one-fit-all type of adjustment. Adjustments greatly depend on the current market conditions (in general, and with respect to the underlying), the option strategy used, your outlook going forward, and the goal contemplated. Let’s take two key examples:
The Covered Call Strategy with an OTM Call
Usually, you sell a covered call if you expect the stock (or ETF) to rise slightly or move sideways. Let’s consider different scenarios and typical adjustments that would be appropriate for each one:
If the stock drops shortly after selling the option due to some market event but you believe it will rise back to its previous level before expiration, you should probably wait and see instead of adjusting, so that you can realize as much premium as possible thanks to time decay.
On the other hand, if you now expect a further decline due to some bad news specific to the stock and your goal is to keep generating some income, you may want to close your current covered call, take a profit, and enter into a new one with a somewhat lower strike to get additional premium. However, if your primary goal is to free up some capital rather than generating income, you might want to adjust with an even lower strike to increase the chances of the short call expiring ITM so that you get the proceeds sooner rather than later, even if this means taking a loss on the assignment.
If the stock rises shortly after selling the option but you think it will decrease back to its previous level before expiration, you should probably wait and see instead of adjusting, again so that you can realize as much premium as possible thanks to time decay.
On the other hand, if you now expect a further increase due to some good news specific to the stock and your goal has changed and you want to keep it for the longer term while generating income, you may want to close your current covered call, take a loss, and enter into a new one with a likely-out-of-reach higher strike. However, if your primary goal is to free up some capital rather than keep the stock or generate income, you may want to do nothing or adjust with a slightly higher strike to increase the chances of the short call expiring ITM so that you get the proceeds sooner rather than later, even if that means taking the risk of missing out on the upside (risk of an opportunity cost).
The Cash Secured Put strategy
Usually, you sell a cash-secured OTM put if you expect the stock (or ETF) to rise, move sideways, or even decline slightly. Let’s consider different scenarios and typical adjustments that would be appropriate for each one:
If the stock drops shortly after selling the option due to some market event but you think it will rise back to its previous level before expiration, you should probably wait and see instead of adjusting, so that you can realize as much premium as possible thanks to time decay.
On the other hand, if you now expect a further decline due to some bad news specific to the stock, and your goal is to keep generating some income, and you would not mind owning the stock at a lower cost basis, you could close your current short put, take a loss, and enter into a new one with a likely-out-of-reach lower strike. However, if your goal is not to own the stock, you may just want to close the position altogether for a loss without entering into a new short put.
If the stock rises shortly after selling the option but you think it will decrease back to its previous level before expiration, you should probably wait and see instead of adjusting in order to realize as much premium as possible, unless the rise is sharp, in which case you may want to take the profit the market is giving you and walk away.
On the other hand, if you now expect a further increase due to some good news specific to the stock and your goal is to keep generating income by selling options, you may want to close your current short put, take a profit, and enter into a new one with a higher strike, maybe ITM.
As you can see from these two simple strategies, there are many different adjustments possible, depending on your views, your objectives, the market conditions, etc. It would be too cumbersome to have them all listed under one lesson given the numerous existing strategies and possibilities for each one of them.
However, you will learn the best adjustments for each strategy as part of being a member of our community. We will delve into the details of each of them and you will quickly learn the essential techniques to help you manage and mitigate the risk of losses, even when the market moves quickly and sharply against you.