Is Your Position More Risky Than It Appears?
Adjusting a Position to Reduce Risk
When we initiate a spread position, there is always a good reason to believe that the outcome is positive because no one makes a trade without an expectation of earning a profit. As all traders know (or quickly learn), some positions will run into trouble because our expectation for the stock market (or our individual stock or index) does not come true. Therefore, the experienced trader knows that there will be occasions when exiting the trade and accepting a monetary loss is the correct decision.
However, the normal emotional reaction for a trader facing that loss is to find some way to 'fix' the position. There is nothing wrong with that approach. In fact, it is wise to look for an intelligent adjustment such that two things are accomplished:
- The more important factor is that the new position must be less risky than the position being adjusted. If we cannot reduce risk; if we merely mask risk so that the position appears to be less risky; that is not just not good enough.
- Second, the newly modified position must be one that you want to own. I cannot emphasize this point strongly enough.
Less experienced traders fall into a trap: They believe that making an adjustment is always the best choice simply because it gives them a chance to recover the cash that has been already been lost. They ignore the fact that the newly adjusted position does not belong in their portfolio -- because it does not meet their conditions for selecting a new position. They fail to recognize that the adjusted position is really "brand new" for their portfolio. NOTE: The majority of traders do not think that rolling a position creates something new. They see it as a change or modification of the older position. In fact, it is brand new because the old position is closed (the previously held options are no longer in your portfolio) and a new position, with brand new options, has taken its place.
Doesn't it make sense to seek new profits (i.e., to recover the loss) by opening a brand-new position -- a position that fits your criteria for a new position? Isn't that better than trying to fix a money-losing, position that has become too risky for your comfort zone? Please remember that hope is not a strategy and it is best to create a position that you want to own. Too many traders feel obligated to roll a position, doing their best to manage risk -- and find themselves holding a mediocre position.
- I urge you not to adjust a position and convert it into one that "is not so bad." There is no reason to create a new position so that it fits into the "not so bad" category. When adjusting a position that you already own, you want the newly adjusted position to be just as good as any other newly created trade.
Successful traders understand that there will be situations in which a position cannot be converted to another that is worth owning. Sometimes a loss must be taken to prevent additional losses. Do not force an adjustment with the hope that all will turn out well in the end.
The Winner's Mindset: Make the Best Possible Trade
It is tempting to adjust a losing trade. It is tempting to fix a position gone awry because no one likes to abandon a position and lock in a loss. The successful trader learns to overcome those temptations. I encourage you to make the effort to do the same.
When deciding to initiate a new position or adjust another, take the time needed to make a good trade -- one that gives you a new position that is worth owning.
Consider adopting the following mindset:
- When trading, the primary objective is to prevent a large loss. Of course, you want to earn money. However, if you choose your trades carefully (using whatever criteria you deem to be desirable), the profits will take care of themselves. NOTE: If you are not a good trade selector, if your trades continue to lose money, then perhaps becoming a long-term investor is the better path.
To survive the trading business, it is important to be certain that your losing trades do not overwhelm the winning trades. This requires good discipline.
- When the market does not perform as anticipated when the risk of holding onto the position has increased, then it is usually best to give up on the original position (i.e., exit or make an intelligent adjustment). You know that you cannot expect to be correct every time that you make a stock market prediction. There is no good reason to face the ever-increasing risk for a position that has not been working.
- To prevent that loss, it is essential to learn how to become a skilled risk manager. This takes time because the best way to gain risk-management skills to learn from your own experience. However, there are guidelines that you want to understand -- while gaining that experience. The first is to know the maximum sum at risk for every trade -- and the probability of losing that amount.
- Once you decide to make a specific trade, carefully consider the size of your position. Be certain that you can withstand the worst case scenario (even though you will manage risk to prevent losing that much).
Rolling: The Most Commonly Used Adjustment Method
Rolling the position falls under the umbrella of risk management because the rationale behind making the trade is to reduce risk. It is not to prevent locking in a loss. It minimizes the chances of losing even more money.
Rolling a position allows the trader to believe that he/she is not locking in a loss, but is postponing the loss-taking with the hope that it will disappear. That is a serious misconception. The trade was unsuccessful and money has already bee lost. When the position is rolled, it becomes a new position and the plan is to earn money from the newly created position. Sure you can think of it as recovering money to offset a previous loss, but, in reality, it is a brand new position and the previous one has been closed with a loss.
However, there is an often-ignored danger when it comes to adopting the rolling strategy. A newly rolled position appears to be much safer to own (when compared with the pre-rolled position) and it feels as if holding onto the newly-rolled position will almost surely lead to eventual success.
Much of the time it is an illusion. Rolling is designed to increase both safety and the probability that the position will become profitable. But, too often the position is not less risky to own -- it just feels that way to the eye of a less experienced investor.
What Is Meant by the Term "Rolling"?
"Rolling" is a strategy most often used by premium sellers. In other words, such traders have a basic trading philosophy -- one where the initial trade generates a cash credit. For example, iron condors, credit spreads, the sale of naked options (single options as well as strangles and straddles). Thus, collecting cash with each transaction becomes their customary way of doing business. Once they have the mindset to always collect cash when making option trades, it becomes natural for them to demand an additional cash credit when the position is rolled.
NOTE: Other traders prefer the idea of buying options and much of this discussion does not involve them or their methods. I just want to point out that an option owner can also roll a position when there is a substantial profit. For example, if you pay $2.00 for an XYZ 50 call, and if the stock rallies, the call may increase to $6.00. The owner may decide to roll the position and take some cash off the table. That is done by selling the $600 call and replacing it with a much lower-priced call option with a higher strike price.
When you decide to roll a position, it is common to roll out (i.e., to longer-dated options). It is customary to roll to farther out-of-the-money strike prices. Thus, a common roll may involve covering a Nov 75 put and replacing it with a Dec 70 put. The problem with this type of trade is that it may not generate a credit. That is okay. Making a good, risk-reducing trade is the top priority. Collecting extra cash may make you feel better, but it should not be a requirement for making the trade. This is a difficult concept for the person with the "I must collect a cash credit for each trade" mindset.
If you find yourself in that situation (no cash credit available), you may think that selling additional options or option spreads is a great way to get that cash. The typical losing mindset is: "I never anticipated that the stock price could decline so far (near $75 and that is why this trade is in danger of losing a lot more money), but surely it cannot go below $70. (That belief has caused many traders to blow up their trading accounts. Yes, the stock can price can go lower. Much lower). Thus, I'll just sell some extra puts with a $70 strike price to get extra cash. That way, when the options expire worthlessly, I'll earn an even larger profit than I hope to earn from my original position. in fact, if the puts struck at 65 are priced high enough (that will depend on the implied volatility) maybe I'll sell an even larger quantity of the 65 put. I know there is no chance that these can ever move into the money."
If you ever find yourself thinking along those lines, then stop. This is the path to ruin. Why? Because traders tend to repeat strategies that work. And when they work well, they get overconfident and increase position size and risk. The problem is not that you are likely to lose money because you sold those puts with a 65- or 70-strike price. The problem arises when you do not lose money because you surely will make the same high-risk error the next time. And eventually the market will do the unexpected, you may freeze and not know how to adjust a position that is poised to lose far more money than you can afford to lose. Or the market may gap lower or higher, leaving you no chance to cut risk and you will incur a huge loss.
Please accept this advice not to adjust positions by making them larger and larger, thereby increasing risk. Sure, an experienced trader may want to increase position size by a nominal 1-lot, but the less experienced trader must learn to develop discipline before thinking about when conditions are right for a minor break in discipline.
For example, an iron condor trader may own a 5-lots of an index iron condor. If and when it becomes time to roll the position, the new position may consist of 6- or 7-lots. Sure, these options may be farther out of the money, but the fact that position size has increased makes the position riskier to own (maximum loss is larger). Note: The problem occurs if the position has to be rolled again -- because the trader will almost certainly increase size is once again.
- Adjust the current position by changing the options to those with different strike prices (farther out of the money) – and usually to a longer-dated, expiry.
- Collecting cash is fine -- but do not make that a requirement. Safety comes first.
Regular readers of the Options for Rookies blog understand that it is sometimes necessary to pay a cash debit when you plan to roll, a position. Refusing to adjust an at-risk position -- just to avoid paying cash for the adjustment -- is an unsound policy. If the new (i.e., adjusted) position is not one that you want as part of your portfolio, then please do not make the trade. Over the long term, it is a superior strategy to take the loss now (i.e., exit the trade) and forget about making an adjustment when the new position is simply not good enough. It is important to only own positions that you want to own.
The Illusion of Safety
When a trader adjusts a position by forcing the adjustment trade to result in a cash credit, the trader tends to ignore whether the trade truly reduces risk. This is tricky because the position appears to be less risky (after, the short option is once again a "safe" distance out of the money) when in truth, it is not.
This companion article illustrates how that faulty reasoning originates. It is an important topic because it should help you avoid falling into a "not-recognizing-the-risk" trap.