Diagonal/Vertical Spreads + Portfolio Risk (Part 1 of 4)

From Our August 2015 E-mail Archives: One of our traders sent a multi-question email about his recent trading. Our Head Trader, Robb, answered with a 1,500-word reply. No one can ever say that Robb is a man of few words! So, we are going to break up the original email into four parts. Today, we present the reply to Question #1 of 4.*


-----Original Message-----

From: Thomas G.
Subject: Trades

Robb,

Hope all finds you well. I have a few questions from my recent trading.

1. Diagonals – In my Trading Plan, it says that if I'm down on the diagonal option spread at expiration, then I either take the trade off the table or use lower lows to exit the trade. If I bought September and sold August and I'm down, then is there a way to sell against it again since I'm down overall in the trade? Editor's Note: We will show the answer to this question this week and the answers to the remaining three questions over the coming weeks.
   
   
2. Verticals – In my Trading Plan, it says keep vertical option spreads until expiration to increase my R/R (Reward/Risk). So, when do you scalp these or take them early, if ever? I placed a trade on CAT this week: a 77.50 / 75 vertical. I'm up a little on the trade and I do believe it will get to 75. However, I'm not as confident in CAT staying below 75 until August expiration with it being this extended to the downside. Maybe I just picked the wrong strategy or time frame; however, if it were to bounce, then I can't just see holding it to a max loss...but I also don't want to cut my winners.
   
   
3. On lower lows, is it a closing low or just a lower low during the day?
   
   
4. When I trade my account, I often have over 20% of my portfolio at risk. If I had less than 20% and I was trading at 2% per position, then I would have 6-8 trades on at a time. Are 6-8 trades of $3k-$4K invested at a time enough trades at a time? I'm over trading currently (I'm trying to work on that!), but I don't want to under trade either.

Sincerely,

Tom


-----Reply Message-----

Hi Tom,

Thanks for your questions. I’ll try to answer them as best as possible:
Editor's Note: Answer to Question #1 below. We will show the answers to the remaining three questions over the next three weeks, respectively.

Diagonals – One of the nice things about diagonal option spreads is that they offer a large number of choices when making adjustments.

In my personal Trading Plan, I allow myself to "roll down" the diagonal to a horizontal (sell same strike as the long call, but the front month) as long as the stock hasn't broken any major support points (mostly the 50-day simple moving average). We did a video on rolling from diagonal spreads to horizontal spreads a while ago. Click the image to the right to watch the archived video.

The biggest risk to making adjustments is that, for the most part, you are making the adjustment out of a place of weakness – where you have a loss and you are just trying to mitigate the loss.

One of the things that I have found is that price action is the biggest proof of telling me whether I got the trade right or not. If the trade is going against me, then it's a good sign that the stock is likely to continue to go against me.

Each time that you make an adjustment in options, you increase your risk and lower your reward. That is why I only allow myself one (1) adjustment per trade since traders (including myself in the past!) sometimes keep making adjustments to a losing trade and all they are doing is digging a bigger hole and adding to their risk/losses. Most times, it is best to just take the small loss and move on to the next trade.

Hope this helps.

Robb

* NOTE: Some original wording has been modified for legibility.