When Adjusting a Position, are you Truly Reducing Risk?

Adjust or Abandon a Position?

Understanding Risk
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When a trader rolls a position, it is done with the idea of reducing risk. However, it is also done with the hope of converting an under-water position into one with an improved chance to recover the current loss --  and see the position come out with an overall profit (counting from the date that the original trade was made). And that mindset can be a problem.

When the true objective of a roll is to keep hope of earning a profit alive, too often the trader loses sight of just how risky the adjusted position is.

The newly rolled position often looks better and feels safer. And it should, because there is never a good reason to adjust an existing position and turn it into something ugly (high risk; low probability of making money). Unfortunately the appearance of additional safety is often imaginary -- and that allows the trader to fall into the trap of believing that he/she accomplished something good with the adjustment when in reality, risk was not reduced by enough to make the adjustment worthwhile.

Do not misunderstand. In order for any position to reside within a trader's comfort zone, there must be something about the position that appeals to the trader. Thus, there is nothing wrong with feeling better about the positions you own -- when compared with the position that you recently adjusted. However, for any strategy (rolling, for example) to make long-term economic sense, the trade must truly represent an improvement (less risky) when compared with the pre-adjustment position. If risk is ignored, or misunderstood, the likelihood of a trader blowing up his/her account increases.

Iron Condor Example:
You opened a 10-point wide index iron condor where both the short put and call options are 60-points out of the money. This position is withing your comfort zone and the premium collected is enough to make the trade worthwhile (i.e., the reward justifies the risk). Time passed and now the short call option is almost at the money as the market moved higher.

You are already losing money on this trade and are concerned about losing more money. Your plan is to practice good risk management technique and you want to get out of this position. However, because you you believe that rolling the position, rather than exiting, is a viable strategy, you want to consider that possibility before closing the position. 

For many traders, there are two criteria for rolling: The trade must be made for a cash credit; and the at-risk option (in this example, that is the call option) must be moved much farther out of the money.

Let's say that you own an iron condor position on INDX (an index with morning-settled, European style options) which, after a rally, is trading near 800. You previously sold  the 810/820 call spread. It is late Thursday afternoon, and there are 10 more trading days before the options stop trading. (That occurs at the close of business on Thursday, the day prior to expiration Friday.)

After some time spent studying option prices and the Greeks (that allows you measure the risk associated with owning the new position), you decide to cover the current iron condor -- yes, including the cheap put spread -- [Quoting myself: "You should consider covering either the call spread, or the put spread, whenever the price reaches a low level... there is little hedge remaining when the price of one of the spreads is “small” ...it is not a good strategy to wait for a “long time” to collect the small remaining premium."] Next, open a new iron condor with an appropriate expiration date.

The new position could be the 750/760P; 840/850C iron condor. Because expiry is so near, it is less risky to move the position so that it expires one month (4 or 5 weeks) later.

When the trade is complete, the short option is no longer 10 points OTM. Instead, both the put and a call are 40 points OTM. Obviously this suits your comfort zone requirements, or else you would not have made this trade. You are pleased with the adjustment. Being short two different options, each 40 points OTM feels so much less risky, and you are certain that the new position represents a much higher chance of earning money.

Let's assume you were able to roll the position and collect a premium equal to $0.50.  NOTE: Depending on market conditions and the implied volatility of INDX options, you may collect an even larger cash credit when making this trade -- or it may be necessary to pay a debit.

NOTE: You will not be able to create a "rule" that fits every situation. For example, at the time that you create the iron condor position, it is not possible to plan for a specific adjustment. You cannot plan to roll the options out to a specific expiry date, nor can you know just how far out of the money the new position will be. For this reason,

it is necessary to know how to make a good decision on which specific adjustment is the most appropriate for you and your tolerance for risk -- in the heat of battle (at the time that the decision must be made).

It also means that you may reach the decision not to adjust. In other words,simply closing the position and taking the profit or loss, is often the best thing to do. 

Of course you can exit any position when you are pleased with the profit. Position adjustment  is not reserved  for times when a trade is in trouble. Locking in a profit is just one more way to cut risk.

Question: Did This Adjustment Reduce Risk?

You made the adjustment above. Was this a reduced risk trade, or did it only appear that way?

Assuming implied volatility (IV) is 30 and that the volatility skew is nothing out of the ordinary, you can calculate the position Greeks.

The 820 call Delta is 35.  If the original position is held through expiration -- with no adjustments -- there is a 35% chance that the 810/820 call spread will finish with both options in the money. That would result in the maximum possible loss ($1,000 per spread, less the premium collected when initiating the iron condor trade).

Now, let's look at the new iron condor. The 750 put carries an 18 Delta and the 850 call has a 16 Delta. The chances that one of these options will finish ITM when expiration arrives is 34%.  Thus, the probability of incurring the maximum possible loss at expiration remains the same. This realization is often an eye opener for traders. NOTE: Sure, you would never lose that much money because you would make another adjustment -- if it becomes necessary. However, the important point is that position risk can be examined in multiple ways.

And for this trade, you (along with most other traders) are pleased that the immediate risk (i.e., being short a call that is only 10-points out of the money) has been eliminated. But don't be fooled into thinking that the new position is a lot safer than the original.

Bottom line: The numbers don't lie -- and that is why using the Greeks to measure risk makes sense. Neither position is safer than the other. The adjustment feels right (and I recommend making it), but it is not 'safer.'  Sometimes safety can be an illusion.