There was an inbound question to me this week regarding adjustments I make on short strangle trades.
For reference: A Short Strangle is a delta-neutral options position that consists of selling equal amounts of out-of-the-money naked puts and calls for a net credit. If everything goes according to plan, the underlying stays in a trading range and I can realize a profit buying back the short options for cheaper than I sold them.
Of course, it doesn’t always work out that simply. Many times, we need to play defense. Defense often involves rolling short options further away from the current price action. In practice, this means buying to close the existing short option and selling a further out-of-the-money option (in the same expiration series) for a combined net debit, which reduces my total net credit in the campaign.
The reader was asking me how I choose my “take profit” limit order following a defensive adjustment. Here was my answer:
I like to take trades off at 50% of my original credit – provided there were no adjustments to the trade.
When adjustments happen, it’s a little more nuanced.
If the adjustments brought in additional credit, then I’ll still seek to make the original profit amount. I’m not looking to be greedy.
But I become quite a bit more discretionary in my decision-making when adjustments eat into our campaign credit. In a case where there isn’t much credit left over for me at all, I will look to scratch out of the trade, buying it back for whatever my current net credit happens to be.
Generally, I don’t like bidding less than 50 cents to close a spread because that means I’ll likely have to hold the spread longer and closer to expiration, leaving me exposed to more gamma risk than I’m comfortable with. If buying-to-close the position at 50 cents leaves me with a loss on the trade, so be it. But it’s worth it to take risk off the table in a trade that simply isn’t working.
In other words, when a trade isn’t working as planned, defense becomes my top priority. If I can make a profit on it, great. But my main focus moves to how I can limit my potential losses.
Trade ’em Well,
Chief Options Strategist
All Star Charts, Technical Analysis Research