Repositioning Options in a loosing trade
Is Adjusting Option Trades necessairly? In a perfect world, all of our trades would be winners. Unfortunately, there is no trading system with a guaranteed outcome.
The way we trade involves probabilities. Even the highest probability trades will be losers once in awhile. If an option trade does not go the way you want to, what do you do? For this reason, it’s important to have rolling and closing mechanics in place. Let’s start with the importance of account size first.
I’m a pretty conservative trader and I feel comfortable risking at most 3-4% of my account on a trade that has a high probability of winning like an options income strategy.
Account Size Importance
Adjusting Option Trades differes for smaller account than larger ones. Larger accounts have a lot of luxuries that smaller accounts do not. For example, if a trade goes against us in a large account, we could hold the losing trade and roll it into perpetuity and hope that eventually the trade goes our way and we can get out for a net profit. It’s harder to do this in a smaller account, as losing trades can eat up a larger amount of the portfolio. It’s much easier to keep our individual trade risk small relative to our portfolio in a large account compared to a small account. If we have a losing trade in a small or large account, we have a decision to make. We have to decide whether we want to roll the position forward in time and keep the dream alive, or close the position at a loss to protect the value of the account. When making this decision, we have a few things we consider:
The best time to close a trade is when you can close it for around 50% of max profit. In doing so you increase the number of winners. Sometimes you enter a trade and you see that you loose money immediately when you put it on.
Through research, we discooverd an optimal closing point for trades based on historical data. We analyzed closing our trade at a multiple of the premium collected for premium selling trades. For example, if we collect $1.00 for selling an option, we analyzed the overall P/L based on closing the trade at 1x loss, 2x loss, 3x loss, etc. We found that closing our trade for a net loss of 2x credit received is the best choice
This means that if we collect $1.00, we would close the trade when the value of the option reached $3.00. This would be a $2.00 net loss. We found that this closing point gives us wiggle room for the trade to revert back to profitability, but also protects us from further losses.
The main objective with rolling a trade is to keep the dream alive, but we don’t pay for this dream. We roll trades forward in time for a credit. It’s important to remember that when rolling a trade, we are locking in a losing trade, and opening up a new low probability trade. If we sell an OTM option to open, a defensive roll is almost always ITM, which means that if we keep the same strike and roll the option forward in time we are opening a short option ITM. This is a lower than 50% POP trade. For that reason, we always ensure that we collect a credit so that we improve our breakeven & cost basis. If we pay for the roll we actually hurt our breakeven & cost basis while opening a low probability trade!
We can adjust our strikes, but we still want to do this for a credit. Usually with naked options this means that we have to roll even further out in time if we want to move the strike closer to the stock price to improve our probability of the option expiring OTM.
The best case scenario for a rolled trade in a short premium play is when the option moves from being ITM to OTM. At expiration this will result in erasing our previous losses, and realizing a profit from the credit we’ve received from the initial trade & roll.
We usually roll our trades 7-21 days prior to expiration to avoid gamma risk & assignment risk that grows as expiration nears.