Stock Options Trading Idea Of the Week

Making Adjustments in a Volatile Stock Market

Subscribers have been writing in and asking for a more definitive set of rules as to when to adjust. For example, what number establishes the point where we are "too short" and must make an adjustment? Others have asked why we just don't always maintain a neutral net delta. These are legitimate questions, and unfortunately, there are no easy answers in a market as volatile as this one has been. It might help to explain the reasoning I have been following lately.

Each day, I watch the net delta position of each portfolio and compare it to theta. If theta is higher than net delta, I know that the stock can move against us by a full dollar and we should enjoy a gain for that day. Of course, lately we would be happy if it only moved a dollar in a day - in the past that was considered to be a big move, but today it is a small one. If theta becomes less than net delta, I check out the portfolio on the Analyze Tab at thinkorswim, checking what will happen at the next expiration if the stock price were to move another 6% - 10% in either direction (if expiration is only a week and a half away, I use the 6% numbers, and if it is more than two weeks away, I look at the 10% numbers). If a large loss appears imminent at one of those extremes, an adjustment would be in order.

As we have talked about in the past, adjustments are expensive. They invariable involve early rolling over (or taking off) options at a strike which is furthest away from the stock. That is the time when rolling over yields a very small amount and taking off involves selling for a lower price than any of the other spreads. It becomes even more costly when we add back on spreads at the other end of the spectrum, usually at strikes which are closer to the stock price - these spreads are more expensive than the ones we sold. In the end, we are buying high and selling low.

In a vacillating market, the best strategy is to avoid adjusting as much as possible to avoid these costs. As much as we would like to be delta neutral at all times, we would go broke making the necessary adjustments to make that possible. When the market takes a big move in one direction, the odds increase that the next move will be in the opposite direction. When a reversal move does occur, we will have avoided making two adjustments, and a gain usually results. There will be months when the reversal does not take place during that month, and we will have to endure a loss for that month. Hopefully, we will gain it back in the next month when at least a partial reversal takes place.

That being said, adjustments are sometimes necessary to avoid a devastating loss in case the market continues to move in a single direction without reversing itself. When the risk profile graph shows that huge losses are imminent, an adjustment becomes necessary to ensure that we will still be around to play another day. It is hard to determine in advance exactly what mathematical parameters should dictate when this kind of adjustment needs to be made, and is often more of an intuitive decision.

The market has fallen by over 40% in one year. Retirement accounts have been decimated. Mutual funds are at lower levels than they have been for years. Everyone with stock market investments is suffering to one degree or another. But there have to be some good buys out there, and it is inevitable that at some point people will start edging back into the market. Who knows if it will happen this month or next, or the month after? But someday it should happen. All it has to do is to stop dropping for us to make exceptional returns in our portfolios. Even though we get longer as the market falls (and get shorter as the market rises), there are times like today when we must tolerate being a little longer or shorter than we would like.

Our goal is to make as few adjustments as possible and still protect against a devastating loss of portfolio value. One way of doing this is to establish, and keep, a wide range of strikes in our calendar spreads. We have already moved in that direction (especially in the Big Dripper), and will continue to do so.

As much as we would love to have hard-and-fast mathematical benchmarks for making adjustments, in this world of higher and higher volatility, it feels more like art than science, more intuition and less reason. It is an uncomfortable place to be for many of us, but that is the way it must be, at least right now.