OPTION WRITER - Managing risk when trade starts to move against you

HungryMind1200

Newbie
2 0
Hello Traders,

Allow me to introduce myself. My name is Eric and I am a retail options trader from New York. I’ve been browsing this forum for almost a year now and this is my first post. I have been studying the market and paper trading for over two years, however I have only been actively trading for about 6 months. I have read quite a few books and gained basic knowledge about the market and these derivatives over the past few years, but I am in no way a trader guru. While I know much more then the average Joe, I still have a long way to go before I can say that I am a proficient trader. Please bear with me and keep in mind that I am a newbie :)


I'm hoping that you can help me refine my strategy and help me become a more successful trader. I have been successfully writing options for extra part-time income for a few months now. I always write verticals to limit my risk and cap the required buying power for the trade. I only write deep OTM junk.


My question is in regards to risk management. Let's say that I write a vertical put (bull put spread) for SPX. We'll say that SPX is trading at 1780 today, and the put spread that I write is 1750/1755. A bit of time goes by, and low and behold, the SPX is now in the midst of a bearish trend trading at 1760 and falling FAST... Based on the overall trend, the spread that I wrote now has a 40%+ change of winding up ITM...

How can I protect myself in this situation? I understand that I can buy the put spread back before expiration... Obviously this is not a route that you want to go down as the spread will have drastically increased in value as it gets closer to the money. Assuming that the downward trend continues, are there any other strategies that can be taken to soften the blow? Can a high premium buyback be avoided somehow?


Any intelligent feedback is welcome. Thank you...



-HungryMind1200
 

A Dashing Blade

Experienced member
1,373 170
. . . I have been successfully writing options for extra part-time income for a few months now.
Congratulations. But that's the nature of option writing . . . .small profit, small profit, small profit . . . . . BANG, wipeout.

I only write deep OTM junk.
To paraphrase . . . "I take in a couple of pennies of profit on a trade that, if it goes wrong, will lose me pounds"

Based on the overall trend, the spread that I wrote now has a 40%+ change of winding up ITM...
I think what you really mean is . . . "Based on the prices ion the market, the market is suggesting that my position has a 40% chance of winding up ITM. However, I realise that no-one has a clue how things will really pan out and that no option valuation mathematics really takes account of the leptokurtotic nature of market returns"

How can I protect myself in this situation?
Ever heard that old adage "The first cut is the cheapest"?

I understand that I can buy the put spread back before expiration... Obviously this is not a route that you want to go down as the spread will have drastically increased in value as it gets closer to the money.
When trading, what one wants and what one has to do are often diametrically opposites.

Assuming that the downward trend continues, are there any other strategies that can be taken to soften the blow? Can a high premium buyback be avoided somehow?
Obviously roll out and down, however I assume your trading european style? If so I would urge you understand how and when deep itm european puts will trade at a discount to intrinsic value.

Please note, I realise that this post may come across as in-your-face, but it is meant with to be constructive.
 

Martinghoul

Senior member
2,690 276
Apart from taking the pain (which is part of the strategy, I might add), you could conceivably turn your put spread into a fly. But all these things are cosmetic. The important thing to do is to think about why you sold the put spread in the first place.
 

HungryMind1200

Newbie
2 0
Hello. Thank you both for the feedback. I don't mind the "in-your-face" approach of the first reply. We traders tend to have thick skin. I would rather hear realistic feedback versus a load of BS. I am trading American-style options, not European.




While the mechanics and interworking of these trades are very important to understand, I find myself particularly interested in the psychology behind managing the trades. There is no feeling worse than that of a self-inflicted wound. Fortunately I try to take risk management very seriously, and I always try to keep around 20% of capital in cash with the intention of immediately walking away from a losing trade at a minimal loss. I try not to remain in any trade for a long period of time, so rolling a losing trade is something that I would rather avoid (no reason to prolong the inevitable loss). I was thinking more in line of hedging strategy for a losing trade to somehow neutralize or capitalize on the loss. Of course, this would be merely insurance and may be unnecessary depending on the outcome of the market at expiration.





I use technical analysis as well as probability models based on IV. This strategy works well, but is certainly imperfect. I made a stupid move this week which resulted in a big loser. This trade started out with a 90% theoretical probability of staying in my favor, but low and behold the market had other plans. This trade moved against me within the course of a single trading day. I reacted incorrectly, as I was overcome by HOPE and sat around to watch a small loser turn into a very big loser. I consider this a lesson learned and I am now looking back to determine how I could have handled it differently. In this scenario, I had a gut feeling that the trade was going to move against me (the writing was on the wall), but I chose to hope for the best. Presuming that the trade will undoubtedly be a loser, here is a thought that enters my mind as to what I could have done differently.








Let's use the example trade that I mentioned in my previous post. We'll say that the SPX is currently trading at 1780:


* SELL-to-open 1 SPX 1755/1750 vertical put spread (sell the 1755 put and buy the 1750 put - bullish trade).


Now let's say that the market starts to move to a place where I become uncomfortable (we'll say the SPX loses 19 points and falls to 1761). I could somewhat hedge the above trade by performing the following:


* BUY-to-open 1 SPX 1760/1750 vertical put spread (buy the 1760 put and sell the 1750 put - bearish trade).









Notice that I am using a wider spread within my insurance/hedge trade. I would need the SPX to expire lower than 1750 to obtain max profit. Without the insurance trade, if the SPX expired lower then 1750, I would take a full loss on the first trade. Although this would be an expensive insurance policy, this would completely neutralize the first loss, as well as take a small profit from the wider spread.



Do you see this as a valid way to somewhat mitigate the losses of a losing trade? My only concern would be the cost of the second trade. I would have to calculate the risk/reward and determine an appropriate exit strategy in the event that the SPX does not move below 1750...



I hope my explanations make sense. I understand that there will be losses in trading. This is inevitable and it is just part of the game... I am just considering different approaches... Thank you again for your feedback.



-HungryMind1200
 

Martinghoul

Senior member
2,690 276
Problem is that when you feel that you need to buy insurance, it will be very expensive. In your example, you will end up owning a 60-55 put spread that you would have net paid a lot of money for (possibly more than the intrinsic). Again, the thing you really need to think about is why you're selling the put spread in the first place. What is your strategy? Why do you expect to make money doing this trade?
 
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