A Critical Look at Option Trade Adjustments

When trading high probability option trades it is about making money even when things don’t go as planned. Whether it’s calendars, iron condors, verticals, etc. it takes patience to see a trade through. Inevitably when someone sees the price move against them the question is always about what should be done to adjust the trade. As I scour the web looking for option related articles this is always something that comes up, and I found something today that puts many of the so called solutions to adverse price movement into perspective.

http://www.option911.com/trades/adjusting-a-butterfly-in-a-trend-the-in-board-vertical-rut-example/

In the above article the author talks about taking half of the middle strikes on a butterfly and rolling them up a strike or two. The effect is to create a slight skew to the trade and adjust the breakeven higher. However, when you look at the new trade compared to the old the total risk increased from $800 to $2000–granted their is less risk in the direction of the trend. Also, the breakeven prices on the RUT went from  637.50/682.50 to 650.75/689.25–which is even more narrow than when it was originally placed. Lets see what was obtained for the additional risk: a 1% higher breakeven price, reduced risk to the upside of $200, but increased risk to the downside of $2000.

Being a fairly low probability trade it makes me wonder with the RUT at 678.97 at the time this article was written how unlikely it will be that the RUT will end up below $650 at some point between now and expiration. Currently the probability that the $650 BE will be touched is approximately 32%. Now the chance of taking the max loss is extremely small right now given the proximity to expiration, but the question is what adjustments will be made if by chance the stock begins to fall and $650 is challenged.

Here’s the point I would like to make regarding adjustments, and this is a perfect example. Without reducing the number of contracts, there is significantly more risk on an adjustment like this that will inevitably be realized at some point over many trades. The out-sized potential loss, and the poor R/R makes you wonder what kind of profits will be had even if the trade works out profitably. Another issue is the frequency of these types of adjustments. When entering a balanced butterfly with about a 43% chance of making a profit, the chance of the stock challenging one or both of the strikes at some point before expiration is well over 50%. This means that this sort of adjustment would be the rule rather than the exception. Think of it this way, would you routinely enter a trade with the profile of a 2/1 risk-to-reward and a 42% probability of profit–sounds like you have better odds at Vegas.

The issue with adjustments is always the frequency of the adjustments. It’s about balancing a stock trading in a very probable area vs making a significant breakout technically. A butterfly by its nature is a lower probability trade with a good risk -to-reward. Why make it what it’s not. If you wanted to have higher odds of success you could have skewed it from the start by setting one end of the vertical a little wider than the other and entering for a credit. This type of trade can be done and achieve a greater than 70% probability of success from the outset.

There isn’t necessarily anything wrong with adjustments assuming that the new trade being put on makes sense. If the adjustment is highly probable, and the result f the adjustment causes you to either increase your risk substantially or provide little or no potential for profit you may want to reconsider. In a later post I’ll address the probability of touching vs expiring in order to gain perspective on the frequency of adjustments purely based on the stock hitting a certain price.

What are some of your thoughts or questions about adjustments? Please post a comment.