Adjusting A 'Trade Gone Bad'

1/15/2017 Adjusting a 'Trade Gone Bad'
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Adjusting a 'Trade Gone Bad' DeCarley Trading on

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 Written by Carley Garner Print Email
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Adjusting a Trade Gone Bad...and Good Adjusting a 'Trade Gone Bad'
The Trading Plan DeCarleyTrading.com

by Carley Garner of DeCarley Trading
@carleygarner
Experienced option traders are aware of the dismal probabilities involved in long An Oscillator is an Oscillator, in the Long Run I assembled my new toy today. It isn't
option strategies. It is often said that approximately 80% of all options will expire called an assault bike for nothing...
Don't Panic, Get Creative with Option Trading @ Las Vegas,…
worthless. Thus, it is fair to say that option buyers will likely lose all or some of their
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investment. Accordingly, option sellers are provided with arguably better odds of
Adjusting Profitable Option Spreads
success. In theory, more often than not, sellers will collect but more importantly 12h
keep, the entire premium of a short option. Naturally, they must be careful not to let Option Spreads Can be Picked Apart
DeCarleyTrading.com
the few losing trades take back all previous profits plus some. Thus, due to the
The Bottom Line @carleygarner
delicate nature of the options market it is imperative that all traders, whether buyers
It's here!
or sellers, have the ability to “repair” option positions in order to maximize their odds All Pages instagram.com/p/BPOlFLnl_zC/
of success.
14 Jan
As with many aspects of trading, adjustments are not an exact science but a skill. In fact, sometimes it is even necessary to adjust
your adjustment. With that said, you must realize when an adjustment is necessary and when doing so will simply add unnecessary DeCarleyTrading.com
@carleygarner
Awesome, thank you and enjoy!
http://www.decarleytrading.com/learntotradecommodities/tradingoptionsonfutures/89adjustingatradegonebad?showall=1 1/14
Awesome, thank you and enjoy!
risk or transaction costs. We have chosen two scenarios in which we would like to demonstrate option repair strategies using a bull call
spread with a naked leg. 13 Jan
An Aggressive but Seemingly Wise Approach to Options on Futures DeCarleyTrading.com

@carleygarner
We've posted a free #trading education
We are somewhat fond of a three-legged debit spread known as a bull/call or bear/put spread with a naked leg. These types of option video on our website, learn about
spreads are consistent with the theory that options are priced to lose. Thus, rather than buying a close to the money option out right, trading commodities "like a girl" :)
ow.ly/gla2307Z6Lk
traders should finance the position by collecting premium through short options. Such a strategy is relatively aggressive shouldn't be
attempted by the faint of heart.
Traders that are expecting a market to rise can increase their leverage, and in my opinion the probability of a profitable trade, through
the simultaneous purchase of a close-to-the-money call option and the sale of a higher strike call option as well as a "safely"
positioned short put. The beauty of the trade is that you can’t lose on all three legs of the trade. In other words there is a built in
diversification mechanism. Conversely, this type of spread involves unlimited risk in the form of a naked put, making it imperative that
traders are prepared to adjust their stance or simply exit the trade should the market turn sharply against the position.
A three-legged spread structured in this way can, and should, be adjusted in two completely different market scenarios; the first being
13 Jan
an attempt to “repair a trade gone bad” the other being an opportunity to “milk the trade for additional profits”.
DeCarleyTrading.com
@carleygarner

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The Trading Plan
As you have heard time and time again, you must have a plan of action going into a trade. The point at which you chose to adjust should
be determined in advance, however every successful trader understands that it may be appropriate to stray away from the original
plan and unfortunately this is something that only comes with experience. When trading Dow futures, a rule of thumb is to convert a
naked option into a debit spread once the underlying future comes within 100 points of the strike price if there is 20 days or more left
until expiration and momentum oscillators are suggesting that the momentum is against the short option position. Another point of
reference as to when to exit a losing short option is what we call the double out rule. If the short option doubles in value from the point
of entry, it is probably fair to say that the original speculation was incorrect and the risk should be taken off the table.
Remember, rules of thumb are created so that they can be broken. In other words, don't fixate yourself on such a general rule that
you ignore everything else around you. Just because the criteria has been met doesn't mean that you should immediately exit the
position and evaluate the situation after. Emotions, namely fear, can make staying calm in the heat of the moment very difficult.
Volatility Doesn't Always Bring Trading Opportunity
Any trader will tell you that April of 2005 was an exceptionally unpredictable and volatile month in the financial markets. One could
have easily been fooled by the chart of the June Dow Jones future. As you know, the Dow traded in a very distinct trading range
throughout 2004, and it appeared as though it was setting up to post similar action in 2005. After peaking in early March, the Dow
appeared to have found support around the 10,400 area. This is precisely the point in which the market found a bottom in January of
2005, providing an opportune time to execute a bullish option spread
According to theoretical data, on the 13th of April 2005 a trader could have bought a June 10400 call option for $2095, sell a June
10700 call for $775 and sell a June 10100 put for $1075. The total out of pocket expense of the spread would have been $245 plus
transaction costs, with a total maximum profit potential of $2,755 ($3000 - $245), the difference between the call strike prices minus
the original cash outlay.
Table 1 Bull Call Spread with a Naked Leg
Option Long/Short Debit/Credit

June 10,400 call Long -$2095
June 10,700 call Short $775
June 10,100 put Short $1075
Total position debit/credit: -$245

Figure 1
However, as we all know, things are not always as they seem. Rather than holding support and heading to the top of what was
believed to be the trading range, the Dow quickly dropped. At this point a trader can do one of three things, liquidate the short put at a
loss, wait and hope that the market rebounds, or adjust the trade.
An Oscillator is an Oscillator, in the Long Run
We have concluded that a short term moving average crossover, such as the 3 and 7 day, provides good indication of upcoming price
moves but should only be acted upon if confirmed by a trend following oscillator such as the MACD using an 8 and 20 day exponential
moving average with a 9 trigger. A combination of a MA crossover and a slower indicator is a better judge of the underlying trend
relative to a quicker oscillator such as stochastics and may help traders avoid premature reaction to false market moves. Keep in
mind, that these are simply personal preferences you may be comfortable with alternate oscillators and as long as you use them
consistently should yield similar results in the long-run. This is because all oscillators are simply mathematic equations representing
what has already happened in the market and are likely equally as effective, or ineffective, depending on how you use them. The
combination of oscillators used should be determined by your risk level and personality combined with comfort level.
Along with help from an oscillator, it is also important to note any known support and resistance areas. A break out with a close near
the high or low suggests that the market will continue in the direction of the move but it certainly isn't guaranteed. As you can see, the
rules of option trading are extremely ambiguous. Accordingly, repair strategies take a great deal of instinct and self-control.
A quick thinking trader can quickly mitigate, or even eliminate, losses on an unfavorable trade by converting the naked put into a bear
put spread. In this example, buying a 10300 put will not only guarantee limited loss on the downside, depending on the time value left
on the trade and other market conditions, it may be possible to profit on the adjustment even though the trader was 100% wrong on
the direction of the market.
However, as you will soon see, this is a lot easier said than done. After all, it is entirely possible that the market could bounce shortly
after buying the 102 put causing a loss on the adjustment as well as the original spread. Additionally, markets tend to gyrate rather
than going straight up or straight down making both entry and exit of the adjustment very confusing. Another factor working against
this type of adjustment is the likelihood of increased price volatility leading to inflated option premium.
Don't Panic, Get Creative with Option Trading
On April 14th, one day after executing a trade that seemed to have a perfect set up, the June Dow Jones futures contract impulsively
dropped though previous market support and settled near the low of the day. At this point, the market has violated many of the
previously mentioned “rules of thumb” in Dow futures trading. Thus, an adjustment seems necessary. Based on Black and Scholes
data, a trader could have purchased a 10300 put on the open of trading on the 15th for $2025. The net result is a 10300 / 10100 bear
put spread, along with a 104000 / 10700 bull call spread above the market.
Purchase of the 10300 put for $2450, if left intact, provides an opportunity to profit on the put spread if the market is below 10100 at
expiration. After all, we originally collected $1075 for the 10100 put and the spread can make as much as $2000 intrinsically. This
would give us a profit of $625 intrinsically below 10100. Conversely, we cannot forget about the money that is lost on the call spread.
Assuming the call spread is held until expiration and expires worthless, even the maximum payout on the put spread would leave the
trader in the hole by about $695 before transaction costs. While this doesn’t sound like an exciting proposition for most futures
traders, it far outweighs the alternatives.
Table 2 Creating a Bear Put Spread from a Naked Put
Option
June 10,400 call Long/Short
Long Debit/Credit
-$2095
June 10,700 call Short $775

June 10,100 put Short $1075
June 10,300 put Long -$2450

Once a naked option is “repaired”, the trader now faces the decision to either hold the adjustment into expiration or attempt to trade
out of it. This can be even trickier than placing the adjustment itself. If not handled properly, a trader can easily be “whipsawed” in and
out of the market resulting in substantial losses.
Figure 2
In the simplest scenario, the Dow would have declined below 10,100 and remained there until expiration. However, the June Dow found
support just about 10,000 and made an impressive rebound forcing a trader in this position to assess the market and determine if and
when to begin “legging out” of all or part of the trade. In a situation such as this, it is critical that a trader not panic and liquidate legs
prematurely. For this reason, similar to entry of the adjustment, exit should be triggered by a crossover of the 3 and 7 day moving
average along with confirmation from the MACD or any other combination of oscillators that you have faith in.
On April 25th, the MACD triggered bullish signal, which confirmed a MA crossover indicating that the market could be headed higher in
the near term. This should also be seen as an opportunity to sell the previously purchased 10300 put. After all, options are an eroding
asset. It doesn’t make sense to hold a long put if technical momentum appears to be pointing towards higher a higher Dow. By selling
the long put on the open of the trading session, the trader may have received $2225, a loss of $200 plus commissions and fees on this
particular leg but worth it in terms of sanity and potential sleep loss.
We are now left with the original trade, a 10,400/10,700 call with a naked 10,100 put and a net cost of $445, rather than $245, and a
profit potential of $3000 with the market set to incline.
In this particular trade, it appears as though a trader would have been better off without adjusting. By keeping the original spread intact
and withstanding the fluctuation, a trader could have avoided the $200 loss incurred and the extra commission paid for the adjustment
put. But keep in mind; the potential loss was much greater.
Adjusting Profitable Option Spreads
As previously mentioned, a three-legged spread such as this can also be adjusted in a scenario in which the market does in fact go in the
intended direction. Let’s take a look at an example in which the trader is correct in the speculative direction of the market and has the
opportunity to “extract” a little more profit from the trade.
Figure 3
In mid July, the Dow made an impressive comeback following the panic liquidation triggered by the terror attach in London. After
analyzing the technical aspect of the market a savvy trader may have found this to be the perfect time to enter the market with a bull
call spread with a naked leg. A failed breakout of the trading range is one of the most reliable indicators for future price action.
According to the information available to us, on July 11th, a trader could have bought a September Dow 10,400 call, sold a 10,800 call
and a 10,000 put for a total cost of $325 before commissions and exchange fees.
Unlike the last example, the market immediately goes in favor of the trade. When trading three legged option spreads, it is important
to remember the old adage “You can’t lose taking profits.” By carefully exiting the trade one leg at a time, I believe that it is possible to
maximize your odds of success while minimizing your risk.
Table 3 Bull Call Spread with a Naked Leg
Option Long/Short Debit/Credit

Sept. 10,400 call Long -$1750
Sept. 10,800 call Short $400
Sept. 10,000 put Short $1025

The bulk of the risk of this trade lies in the naked put, thus this is the first leg that we will look to liquidate with a profit. Once again we
will look to technical analysis to guide our decision, however this time we will also monitor the time premium erosion of the naked put.
Option sellers should consider taking profits, and risk, off of the table once the value of the option has eroded to less than 40% of the
premium collected. From there decisions should be guided by the direction and stamina of the current trend measured by technical
indicators such as the MACD. If it gets to the point in which 80% or more premium has eroded, you should no longer be considering
whether or not to buy it back you should simply do it.
On July 18th, the value of the September 10,000 put has declined to $400 meeting are criteria to begin consideration of buying the
option back at a profit. Next, a trader should look to their favorite oscillator to determine the direction in which they believe that the
market will go in the short term. If indicators are pointing towards a rally, a trader would be best off holding out in hopes of additional
profit. However, if it appears as though the market might weaken, it is time to take profits on the short put. On July 25th, the trend
oscillators are beginning to look as though the market is prepared for a correction. Additionally, the Dow is finding significant
resistance as it approaches the June highs. At this time, a prudent trader would look to buy back the put for $350 according to
theoretical values to take a profit of $675 on that particular leg. This is a good idea even though the oscillator hasn’t actually given the
signal.
Figure 4
The offset of the put eliminates a significant amount of the risk in that there is no longer unlimited danger, and leaves the trader with a
limited risk bull call spread. The next step in the adjustment process is to sell the long 10,400 call. Similar to legging out of the put,
selling the call should be based on technical analysis. Naturally it would be ideal to liquidate the call option at the top of the market,
but I think we all realize that this is easier said than done. Once again, we should rely on the MACD to guide liquidation of the long call.
At the time of the MACD crossover, a trader could have collected $3225 for the 10,400 call option to net a profit of $1475 before
commissions and fees.
Figure 5
Option Spreads Can be Picked Apart
At this point the only remaining leg of the trade is a short 10,800 call, in which was originally executed as a credit of $400 and is now
worth about $850. This represents a $450 paper loss on this leg of the spread. In line with the proverb “have your cake and eat it
too”, a trader can hold the short 10,800 call in hopes of the market weakening and thus depreciate in value and add to the overall profit
of the trade. Once left with a naked call, a trader should look at the remaining leg as though it were executed for the sole purpose of
premium collection. This may avoid temptation for excessive greed or just the opposite, undue fear.
Table 4 If you exited the short call along with the long call.
Option Long/Short Debit/Credit Exit price P/L

Sept. 10,400 call Long -$1750 $3225 $1475
Sept. 10,800 call Short $400 $850 -$450
Sept. 10,000 put Short $1025 $350 $675
Total position debit/credit: -$325 Total P/L: $1700

Although the short call involves risk, it provides a trader with attractive odds. After all, time premium will decay on the option
regardless of whether the market trades higher, lower or sideways given that the market doesn’t rally too quick and too far. With a
current value of $850, unless the trader expects that the market will rally to 10,885 by expiration, there is little justification in buying
the call back. In other words, it only makes sense to buy back the option if the trader believes that the market will be above 10,885 at
expiration because this level represents the trader’s intrinsic break-even point based on the value at the time that the long call was
offset.
If everything goes as planned this option will lose value and allow the trader to buy it back at a discount. The best-case scenario would
involve an impulsive drop ensuring that the 10,800 call expires worthless. If this is the case a trader would have profited on all three
legs of the option spread. Let’s do the math, we made $675 on the short put, $1475 on the long call and can potentially make another
$400 on the short call for a total of $2550 before commissions and fees ($850 better relative to the timing of the exit of the other
two legs which would have netted $1700). Don't overlook the fact that there were three contracts traded and would have created
three round turn commission charges.
While this is less than the $3675 ($4000 - $325) maximum payout at expiration, I believe it to be more likely. In order for the original
spread to return the maximum payout the market would have to be above 10,800 at expiration. Given the technical climate of the
market and the seasonal weakness it doesn’t seem a probable outcome. Additionally, holding a trade too long can often lead to a
winning trade turning into a losing trade. Accordingly, I am of the opinion that taking profits one leg at a time reduces a trader’s
exposure to the market while increasing their odds of success.
The Bottom Line
In conclusion, options are an extremely versatile trading tool with the ability to provide traders with a potentially lucrative alternative
to trading futures contracts. However, in order for option trading to be effective it is sometimes necessary to make adjustments and
even repair a particular trade. With a combination of skill, instinct and luck the flexibility of options offers traders the potential to
profit in a market regardless of its direction.
**There is substantial loss in trading options and futures.
Carley Garner, senior analyst at DeCarley Trading, is the author of "A Trader's First Book on Commodities" and “Commodity
Options” published by FT Press, a division of Prentice Hall. Her trading e-newsletters, The Stock Index Report and the Bond Bulletin, are
widely distributed and have garnered a loyal following; DeCarley Trading is proactive in providing free trading education.

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Adjusting a 'Trade Gone Bad' DeCarley Trading on

The Trading Plan DeCarleyTrading.com

An Aggressive but Seemingly Wise Approach to Options on Futures DeCarleyTrading.com

The Trading Plan

Volatility Doesn't Always Bring Trading Opportunity

Table 1 Bull Call Spread with a Naked Leg

Option Long/Short Debit/Credit

An Oscillator is an Oscillator, in the Long Run

Don't Panic, Get Creative with Option Trading

Table 2 Creating a Bear Put Spread from a Naked Put

Adjusting Proﬁtable Option Spreads

Table 3 Bull Call Spread with a Naked Leg

Option Long/Short Debit/Credit

Option Spreads Can be Picked Apart

Option Long/Short Debit/Credit Exit price P/L

The Bottom Line

**There is substantial loss in trading options and futures.

Carley Garner Trading Books

Commodity Trading Archive Tag Cloud

learn to trade trade futures trade commodities commodity options

Risk Disclosure Contact Us.

+1 (866) 790-TRADE (8723)

DeCarley Trading RSS  www.HigherProbabilityCommodityTradingBook.com

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