Options trading adjustments — The good, the bad and the ugly!

Just like with everything else, our Indian #fintwit remains divided when it comes to options trade adjustments too. There are two schools of thoughts — First comes the section which sells workshops around adjustments and portray these adjustments or the so called firefighting techniques as some kind of a holy grail - something that will save you from any kind of move in the underlying and help you come out in green every single time. We all know that’s far from reality and some trades work and some trades don’t. Those who actually trade know it very well so I’ll leave that there. Then there is an “elite” section who likes to discard the adjustments completely. Per them, if you are putting any adjustment to a trade, it’s not an adjustment but rather a whole new trade altogether. “Bhai nayi trade bol lo aur adjustment mat bolo, happy? Didn’t Shakespeare say, “What’s in the name”? In this blog, we will look at adjustments and how they are important when you are trading options volatility and are selling options. Before we do that, I want to quickly touch upon a few things that will be used later for this same discussion.

Probability of an option expiring ITM — This is the probability or the chance that any option will expire ITM at expiry. A lot of traders use delta as the close proxy to this which in most cases might be right but can be off by a lot in many other cases. Let’s look at the maths of these two as per BS model—

d1 = (ln(S/K) + (r+v²/2)*t) / v²*sqrt(t)

d2 = d1- (v²*sqrt(t))

where S = Stock price, K = strike price, r = interest free rate, v = volatility, t = time to expiration in years

Once we have the d1 and d2 numbers, delta is calculated as N(d1) and probability of ITM as N(d2) where N gives us the area under the standard normal distribution table.

As can be seen from the formula, d2 is going to be significantly lower in a high vol regime. A very high vol period like Covid-19 is likely to see the delta of an option to be a lot more than the probability of it expiring in ITM. Nevertheless, we now know that there is something called as the probability of ITM and we are going to use that in the subsequent discussion.

Probability of touch — For an OTM option, the probability of touch or POT indicates the probability that option will become ITM at some point in time before expiry. Note this only means that underlying will go to that option strike at least once in its lifetime and become ITM at that point but doesn’t necessarily mean that it would expire ITM and that’s the difference between prob of ITM vs prob of touch. POT is generally two times the prob of ITM. So, if we got the probability of an option expiring ITM as 20%, the probability of touch will roughly be 40%.

Selling strangles vs straddles and the adjustments — Now let’s talk about the trade ideas and the adjustments. When trading volatility, one frequently traded idea is to take advantage of high volatility, try to capture the risk variance premium and short volatility or in simpler terms sell options. This is done mostly by creating a structure that is delta neutral and the bet is not on direction but on the fact that realized vol is going to be lower than the implied vol. Of course, there are a lot of other considerations that go into and one doesn’t simply sell options only because volatility is high. These could be IV staying above the HV for a certain lookback period, IV being high due to some news or an event ahead like corporate earnings to name a few. While a lot of traders completely discard the idea of selling strangles while shorting volatility, but I like to keep my vol short option book to be a mix of defined risk and undefined risk including straddles as well as strangles too. A few reasons for this are —

1. Vol is not uniform across the option chain and some strikes have unusually high vol (also called as skew) so it offers a better opportunity to sell those strikes rather than simply selling straddles.
2. Theta decay curve of all options is not the same. When the time to expiration is more, theta decays faster for OTM options compared to ATM options as can be seen from the below image. So earlier in the expiry, it makes perfect sense to choose strangles over straddles.

3. 20 delta strangles would provide wider breakevens as compared to the straddles and at times when the market is choppy with fast moves both sides, the PnL bleed will be much lesser compared to the straddles.

Adjustments: The Good — Now let’s talk about adjustments. When you choose to sell strangles, you are basically betting on three things and expect to make profit out of one or many of these —

1. Implied vol goes down and realized vol stays lower than the implied vol.
2. Theta decays as the time passes and you get a certain component of theta in your PnL.
3. Underlying doesn’t move much and doesn’t require you to adjust/hedge your position often.

But in case it doesn’t happen and say the underlying starts to move on the upside. You started with a 20 delta strangle but now call delta has become 35 and put delta is down to single digit. If you don’t do anything in such a case, your trade is no longer a delta neutral or a vol trade anymore and it has become a directional trade. You’d expect to make money in case of a reversal and not simply because vol goes down. So, in order to stay afloat you’d like to rebalance your deltas (provided the underlying idea with which you initially took the trade is still valid — implied vols still being high enough for you to stay in the trade) and in order to do that the most common method is to roll the sold puts up. Whether one calls it adjustments or calls it delta rebalancing, the underlying idea remains the same and it’s a very valid mechanism to sell vol and trade profitably. This in my opinion is a good way to adjust our short strangle position and there is nothing wrong in that.

Now let’s go back and bring back the POT that we learned earlier in this blog. If we sell 20 delta strangles and assume the prob of ITM is 18%, then there is roughly a 36% chance that one of the short strikes will get touched once before the expiry and even more probability that position gets tested on one side as the PnL might be negative when deltas get imbalanced say one of the strikes delta goes to 35.

What do you do in such case if not adjustments — book loss and look for a different trade? If that’s how we look at selling vol then there is a good chance that about half of the trades that started with 70–80% POP will be taken off with a loss. When selling strangles in high vol environment, we rely on the market’s nature to mean revert. If we simply take off the trades after a one side move in a high vol environment, we are not giving enough time to our trades to play for the mean reverting nature of the market. We are also not realizing that high probability of profit (POP) with which the trade was initiated. Adjustments are done in order to keep the short volatility trades alive for a longer duration.

To those folks who suggest that if one is good at adjustments, then they should only take adjustments trades - I find it very amusing as does anyone know upfront which trades would work outright and provide smoother PnL and which ones will not work at the start and might require some adjustments? It’s only known in hindsight.

Moreover, let’s say you sell a Nifty straddle at 16500 and nifty moves to 16800. In order to delta hedge, you move the Nifty straddle to 16700. If you are good at delta hedging and believe the trade placed in order to delta hedge are the ones making money, why not just delta hedge and take those trades only? Why sell 16500 straddle in the first place and not wait for 16800 to come so that you could have sold 16700 straddle.

Similarly, if you sell put calendars webinars where you advise to go long on LEAPS and short the weekly/monthly in the ratio of 2:1 and the underlying starts to move on the upside, why would you advise to “adjust” and roll the short puts up? Is it considered an altogether new trade or an adjustment? Why initiate the put calendars in the first place and why not simply sell weekly puts when the market moves higher?

Adjustments: The Bad — Like I have said previously, adjustments should not be seen as some kind of holy grail. There are trades that work and trades that don’t. So, it’s best to accept loss in some cases instead of repeated adjustments one after another. People like to sell more puts if the position is getting tested on the upside and vice versa but that doesn’t always end well. A sharp reversal and the whole position goes for a toss.

Adjustments: The Ugly— And then there are ugly adjustments and must be avoided under all circumstances. Say you sold a 16000 and 17000 strangle with Nifty at 16500. Nifty moves to 17k and your short call strike is touched, you buy a 17k call and sell 3 lots of 17300 calls at zero cost or receive a small net credit in this new 1:3 call ratio trade. Nifty next moves to 17300 in the next couple of days, you again initiate one more ratio in order to take your breakevens even higher. This kind of adjustments techniques are real bad for reasons like

1. They are cost ineffective and require you to bring more and more money on the table in order to defend a losing trade. The initial trade might have required 2L margin but these adjustments needed 6L more margin. So, it’s plain dumb and a bad way to manage positions.
2. Adding more and more gamma risk on the same side where the position is getting tested. This can get worse even more quickly than one can realize. People have the perception that call selling is easy money but believe you me, a lot of times there’d be fierce moves on the upside as well.

Similarly, selling more number of options on the untested side is again an ugly adjustment. I once was guilty of doing the same and paid heavy price when I lost 3.5% of my capital in one of those trades. Sometimes overconfidence lets you do stupid things. You’d be surprised to know that such adjustment techniques are being sold in workshops and webinars in the name of firefighting techniques. I hope this blog serves as a good starting point for the aspiring traders to understand some of the nuances of options trade adjustments.

I have written a couple of other blogs and done some videos on adjustments that are available on my channel optionsX. Do check and subscribe — https://www.youtube.com/c/OptionsX?sub_confirmation=1

Happy trading!!

Image source — Options time decay: it does not affect options the same way (myoptionsedge.com)