Over the many years that I have been a trader I have talked to and/or observed literally hundreds of other traders and in all that time I can think of maybe a handful of option traders that I know who were successful. Most every other option trader has lost money and many of those have blown up their accounts at least once and some several times. Why is that? Why is trading so hard for so many? There’s a whole list of reasons including many psychological faults that all human’s share but there’s two main reasons that I deal with over and over again in this blog. One is the difficulty most traders have in setting aside their underlying bias with regards to price action. We all have seen the perma-bears and perma-bulls that fill our twitter accounts. They make lots of money when the market matches their bias and they lose it all when the market doesn’t. If you’re waiting for the price action to match your bias you’re doing it wrong! It’s up to you to figure out the market’s current bias and to then match your bias to what’s actually happening. If I’m holding a long Delta (bullish) position I’m constantly looking for evidence of where the bears are taking control of the price action. My bias is *completely* based on the price action and I simply trade from one level on a chart to the next. I mentioned there are two main reasons that traders lose that I deal with in this blog. The second reason is even more important than the first; most traders have no idea how to manage their position’s *risk*. I believe I could drop most traders into a profitable position and the majority would hold it until it turned into a losing position before exiting it or watching it expire worthless. I don’t say that to demean anyone. They are trying to make it work. They just don’t know what to do. That may apply to you and, if it does, by the time you’ve finished reading this post that should no longer be the case! I’m going to walk you through a position that I currently hold and the various ways I can reduce my risk to the point where I can eliminate any possibility of losing any of my initial capital in the position. In fact, I can lock in a profit while continuing to have the potential of a much greater profit! Once you understand the technique that I’m about to explain it should forever change the way you look at option trading!
Before I explain the Delta Hedging (DH’ing) technique of reducing risk let me just mention that if you have trouble understanding price action you will find many posts in the blog covering that topic. I’d suggest starting with the Understanding Price Action post. Ok, on to the option discussion!
Below is the trade I made on 4/13/22. That was just 1 trading day ago. Based on the price action I wanted a short Delta (bearish) position so I sold a 10-lot of the Jun17 SPX 4450/4550 Call Vertical Credit spreads for a $54.25 Credit. I took on $45,750 of risk to potentially make $54,250. First, don’t worry about the size of the position. This could have been done as a 1-lot SPY spread for $457.50 of risk so this technique is not only for larger accounts!
Most option traders recognize a simple Credit spread. Nothing complicated there, right? Since SPX has moved lower since I initiated the position I have a open profit. Now, if SPX had moved up in price instead of down I might have been stopped out of this position for a relatively small loss. All of my trades have a stop level associated with them so if the price of SPX doesn’t do what I expect it to then I’m out of the trade and on to the next setup. It’s essential to have that attitude with a trade! It should either perform as expected or it should be kicked to the curb! On the risk profile below you can see my current position. Now what? Close it and take the $5,000 profit or hold out for a bigger profit? Well, that’s two possible things I could do but those aren’t the only choices I have.
In the position shown in the risk profile above my Delta (directional) risk is -131. That means if SPX moves higher I’ll lose *approximately* $130 per SPX point. For instance, a 40 point (less than 1%) move higher in SPX and I’ll lose around $5,200. Oops, there goes my $5,000 profit. Well, I could just hold the position for another day and see if I can make back that loss. What if SPX goes up another 40 points the following day. Oops, now I’d be sitting on a $5,000 or more loss. Sound familiar? Ever had that happen to you? Of course you have, it’s happened to all of us! So what’s the solution? Actually, there’s *multiple* potential solutions but I’ll show you just four of them so you get the idea. Keep reading, we’re getting to the best part now!!!
Below is the risk profile of the first adjusted position. Just prior to the close of the previous trading day I could’ve bought a 10-lot of the Jun17 SPX 4300/4400 Call Vertical Debit spread for a $65.40 Debit. That would take the net cost of the position from a $54.25 Credit (with a $100 margin requirement) to a $11.15 Debit with a $0 margin requirement. With this adjustment to my original position I would now own a Call Condor with a maximum loss of $11,150. That would reduce my risk by 75% (from $45,750 to $11,150) and I’d still have the potential of making a $88,850 profit. Also, when I talk about reducing risk I’m not just referring to dollar risk. I’m also talking about Delta risk! The Delta of this adjusted position would be -27 instead of -131 in the unadjusted (original) position. If SPX went up by 40 points I’d only lose about $1,000 instead of the $5,000 if I had just held onto the original position. So if SPX started moving higher and I was no longer bearish I’d still be able to exit this adjusted position for a decent gain. What else could I do?
The risk profile below shows a simple roll-down of the 4550 strike Call to the 4460 strike. The net effect of that adjustment is to narrow the spread from $100 wide to just $10 wide. There is still a margin requirement since this is still a Credit spread but it’s been reduced by 90% and with this adjustment the least I could make on the position is $600 at expiration and the maximum profit would be a $10,600 profit at expiry. That’s right, if I had made this adjustment I could not do any worse than make $600. That’s not to say this a *no risk* position however. There is no such thing as a no risk position! That’s because my current profit is $5,000 and I could give back all of that except for the $600 minimum guaranteed profit. That means I could lose $4,400 of my current open profit. The Delta risk after this adjustment would be -12. What else could I do?
The risk profile below shows two adjustments this time. I could roll-down the 4550 Calls to the 4500 strike and also buy the 4350/4400 Call Debit spread. That would create a $50 wide Call Condor with a minimum $800 profit and a maximum $50,800 profit. Delta risk would be less than -10.
Below is the final adjustment that I’m going to show you in this post. If I wanted to lock-in a greater profit I could turn the position into a Call Butterfly spread with a minimum $2,100 profit and a maximum $52,100 profit. The Delta risk on this position would be less than -5. This adjustment relates to a previous post that I made where I discussed putting a position on hold. With virtually no Delta risk I could turn my current position into this Butterfly if I saw a potential bullish move on the SPX chart. Sticking to the example of how much I’d lose if SPX moved 40 points higher, if I owned this Butterfly, a 40 point move in SPX would probably cost me around $200. That means I’d still have around $4,800 of my current $5,000 profit. Then, later, if the chart looked like another move lower in price was coming, I could reverse the trades that turned the position into a Butterfly or I could simply add a new bearish position since this one has locked in a profit. Sometimes I add a new position and sometimes I reverse the adjustment. It’s good to mix it up a bit to increase your trading skills!
So there you have it! I’ve show you multiple ways to adjust a position to reduce both dollar and Delta risk. It removes the difficult decision most traders have of ‘do I keep this position or do I close it’? As you have learned those aren’t the only two choices. I’ve lasted all of these years by constantly reducing risk while building large positions where I’ve removed all of my initial risk! That increases my leverage without increasing my portfolio’s initial capital risk. It’s kinda like playing with house money!
Questions and comments are always welcome here or on the twitter feed.
this is brilliant. Why do you use SPX AM instead of regular PM expiry?
I’ll use either regular monthly or the weekly’s, whichever I can get a better fill at the time I place the original order. Once I get one leg filled I stick with that expiry to avoid having both monthly/weekly expirys in the same position.
this is brilliant!
Thank you! You may find it helpful to plan your first trade ‘adjustment’ Delta Hedge (DH) before you’ve even initiated a new trade. Since I trade based on a chart level I also plan and actually rest a DH order at another level. For example, let’s say I decided to buy a Put on a failed breakout above a prior day’s high. The next price level target for that trade could logically be prior day’s HB (midpoint). I’d typically rest an order to sell a further OTM Put if price reached that level. My goal at that point is often getting to a net zero cost Vertical spread position. I could then rest another DH order to sell a further OTM Put Credit spread if price reached prior day’s low. That could create a Butterfly or Condor with a guaranteed profit locked in.