Investoid

One of the most important concepts in options trading is that of adjusting a position. Since you’re dealing with derivative instruments they behave in a non-linear fashion with respect to the underlying security. As a result, you can have great percentage changes in your position based on movement in the underlying. Since we’ve had so much volatility recently, your position can go very quickly for or against you. But it doesn’t always make sense to simply exit a winning or losing position. Instead, you may want to make some adjustments to your trade and lock in some gains or to counter the losses.

For instance, I purchased a 27.5/30 Aug strangle on Cisco (CSCO: Nasdaq) to capitalize on an expected move due to its earnings announcement. I purchased the options well in advance, since the implied volatility of such options historically increase greatly as the earnings date approached (and subsequently crashes after the announcement). I was planning on holding the straddle until only before the earnings date, and take advantage of the increase in the implied volatility (which increases the value of the options). I was hoping that the stock would move a bit as well to put one of the options in the money.

In the end, the stock approached 30 before the earnings date but still hadn’t crossed it. My position was slightly positive (I was up about 5%), and so I was faced with taking a small profit or gambling that the stock would move greatly after the earnings and make up for the loss in value that was sure to occur by the reduction in implied volatility. I decided to take my profit, but I needed to have at least one of the options sold at the ask price (as opposed to the bid) to make it worthwhile. I placed two limit orders and was going to cancel one and make it a market order once the other hit.

Unfortunately, I got distracted at work and didn’t get back to the trade until right after the markets closed. One of the orders hit, but the other didn’t, meaning I now had a directional position that I didn’t want. Cisco rocketed up after hours and instead of a mildly profitable trade I had a losing position (mental note: look for a broker that has special order software for multi-option positions).

Instead of exiting my position, I should have been looking at an alternative that would have reduced my risk in exchange for more limited upside. As I thought about the trade last night, I realized I could have sold some 32.5 calls (and possibly some 25 puts) for a credit (cash to me), meaning that I would have increased the current profit on my trade. This would have converted my position into a short (the wings) iron condor. If the stock hadn’t moved that much and stayed between 27.5 and 30 after the earnings announcement, I would have only lost a limited amount of money compared to what I would have lost with only having the strangle. If the stock moved up even a little, or down substantially (over 10%), then I would have made some pretty decent money but less than if I had kept my existing position. The reduced profit would have been well worth the peace of mind that would have come from me not having the proper trades in place (or time to monitor them) to exit my position.

Adjusting positions over time to account for changes in your opinion, strategy, or the movement in the underlying is an important lesson to learn. This one was an expensive one for me, but hopefully I’ve figured out when the realize it’s better to modify that exit entirely.