Adjustments

If you searched online for options trading, you have undoubtedly run into talks of “adjustment”. I did a search myself for option position adjustment, and ran into lines like this:

“Making trade adjustments incrementally can improve your performance by helping you to manage risk and reduce losing trades.”

“Understanding and using Trade Adjustments produces confident and consistent traders. Don’t hope that your winning trades outweigh your losing trades, but instead master the art of adjusting trades and take control of your financial future”

“Making options spreads adjustment trades, by closing option legs with trading method setups, can increase the overall profitability of the spread.”

Wow, by the sounds of it, adjustments can turn any losing trade into a winning one! And better yet, any winning trade turns into an epic trade! All you have to do is master this fuzzy art of adjustments, and you will be rich!

Of course, this isn’t true. By using buzzwords that resonate like “manage risk” and “taking control of your financial future”, lines like this give a false impression. “Adjustments” is a nice way of saying that you have to change your position because something unexpected happened or you are trying to be prudent with your capital. Many of these sites also tell you how to adjust, where this is not a good practice.

I will agree with one thing these sites say, and that is adjustments are an art. There is no one way to adjust, nor should there be a “schedule” of adjustments; that is, when something happens you automatically adjust a certain way. It is a good idea to have a plan for adjustments when you put the position on, but know that the adjustment plan can change for any number of reasons. One of the hardest aspects about options is the fact that there are multiple variables that need to be considered when applying and adjusting trades.

To the option trader, an adjustment isn’t so much about capital, it is more about the greeks. Further upside projection to a trade that already is positive delta may require an adjustment that increases delta. A projected announcement of a catalyst that isn’t realized in options yet would mean you want to increase vega.

In my mind, there are two kinds of adjustments, expansive and corrective.

Expansive adjustments are when a risk to the thesis plays out, say a possible drop happens instead of not, and you decide this is a good time to apply more capital to a trade because the drop increased your degree of confidence in the thesis has increased, or there are now fewer risks. A good comparison using stock is “dollar cost averaging”. A stock heads down to support before it heads to resistance, so the stock trader buys more stock to take better advantage of the bounce. Can the stock plunge through support? Absolutely, and the stock trader loses double. Hopefully the stock trader has a tight stop so it isn’t as much of a problem.

With options, on an OTM vertical, sometimes I will add to the same position as an expansive correction. The advantage is that it costs much less capital to do so, like dollar cost averaging. But the position needs to be traded by the greeks, not by the capital or worse yet, the profit. Another example is if an equity goes up faster into an OTM calendar than I anticipate (a theta positive position), I may adjust the position to realize more profit if the thesis projects further upside like moving the short strike up.  In short, expansive adjustments would be increasing the greek exposure you think will move most. Usually that is delta, and usually it is based on the thesis, not on the trade itself.

Corrective adjustments are when something unexpected happens and you need to reduce your exposure to a greek. That unexpected happening could be a good thing, like your price target is reached before you anticipated… therefore you take your position off and you collect your profits. Perhaps a position goes against you, but you still believe it will bounce, you can use a corrective adjustment to reduce the pain if it never does. Maybe IV has gone up way too much, and you have a vega positive position… you can make moves to reduce your vega.

Here are a few things I have learned to avoid when adjusting:

• The ugly cousin to the corrective adjustment is the reversal adjustment. Lets say you have a delta positive position, and the trade goes against you. Instead of sticking to your original thesis, you try to capture some of that move down before you think the bounce up will happen. NEVER do this. If your thesis is a long term uptrend, with possible short term downward pressure and you are so sure of the short-term downward pressure, either put on a short-term trade separate from your long-term trade or take off your long-term trade. Do not trade against your thesis.
• Do not adjust to theta. Theta represents the amount of IV apportioned to time passing. Time does not change, but to hurt other greeks in favor of more theta can hurt your position more than theta can help. Sometimes I use Theta/delta ratio to help me gauge how much I’m hurting the other greeks in favor of delta, keeping my thesis in mind of course.

• If the trade is “scary”, that likely means you have too much capital invested or do not understand the trade. I would figure out which adjustment makes the most sense while simultaneously reducing capital. Emotionally, severely overweight positions automatically reduce profitability. If you make a quick profit, you sell, perhaps not realizing the full potential of the thesis. If you lose, you wait until you have lost too much to get out mainly because options have massive swings in unrealized profit and loss that can create some anxiety.