From Our May 2014 E-mail Archives: If you have ever had a max loss in an options trade before expiration (okay, who hasn't?), then you need to hear why making an adjustment can often lead to larger losses. Our Head Trader a, Robb Reinhold, answered the question, plus described the concept of merger arbitrage.*
-----Original Message-----
From: Travis J.
Subject: Question
Hi Robb,
I am in a Bull Put spread on Valero Energy (Ticker: VLO). I have the May(4) weekly 56/58. I am currently at max loss right now. Tell me why it is not a good idea to buy back the short leg and let the long put run since the stock is dropping.
Thanks for your time,
Travis
-----Reply Message-----
Hi Travis,
Thanks for the email – this is a good question. What you are talking about is an adjustment of a strategy. In theory, adjustments are great since you can take any position that is a loser and, technically, turn it into a winner. If done correctly, you will never need to take a loss at all!
In reality, though, it doesn’t work as well. The reason: Every time that you click the button to submit an adjustment, you will get results based on your long term win/loss ratio. So, let’s say a trader has a 50/50 win/loss ratio. So, on average over time, the adjustment will improve the position 50% of the time, but it will also be the wrong decision 50% of the time. This would be fine if the Risk/Reward (R/R) didn’t change. However, the R/R changes on all adjustments and most adjustments will open up a bigger max loss potential.
Let’s take your VLO as a great example. You are short the 58/56 put spread and VLO is currently [in May 2014] below $56/share, creating a losing position. Let’s say that you are at a max loss of 1.00 (having collected a 1.00 credit originally).
Once you make an adjustment by buying back the short leg, you will effectively lock in the max loss on that contract. Your remaining long put will be considered a new position at its current price. The May 23rd long put is currently trading at 2.12 per contract. So, after the adjustment, your max risk increases from 1.00 to 3.12 overall. If VLO stock drops in price and you could sell that long put (currently worth 2.12) for 3.12 before expiration, then you would erase the 1.00 loss in the original spread and effectively break even. If you can sell the long put for anything above 3.12, then the original spread plus adjustment would be in an overall profitable position.
If the adjustment works out, then it was a great trade. However, we also have to look at the other side since VLO stock could jump higher before expiry. Without any stops, you have effectively added $2.12 to the original 1.00 max loss. In the worst case scenario, you could take 3X the size of loss you had originally planned for.
So, here’s Maverick Trading’s (and my) position on adjustments. Using your VLO trade as an example, if that long put after adjustment is the absolute best new short position that you can find in all of the stocks in the ENTIRE market, then make the adjustment. Simply treat the remaining long put as a “new trade” and either have a $1.00 stop or reduce your position size in half to maintain proper position sizing.
Knowing that I could most likely find a better new trade idea, I would leave VLO as a max loss and enter a new short position in a better trade/different stock, then follow correct position sizing and management on that new trade.
In summary, I consider a trade adjustment a new trade. If it follows everything that I am looking for in a new trade, then I am okay with it. Just be aware that 99% of the time that traders make adjustments in a losing trade, it is because they are emotionally invested in their position and they want to get their money back in that trade. This is a common pitfall of trading. Don’t fall for it!
Hope this helps,
Robb
* NOTE: Some original wording has been modified for legibility.
