Chris, It's nothing complicated. Let's say you had an OEX IC with the following strikes: 490/500/540/550. Let's further suppose that with the OEX at 531 and change, you were now concerned about your short 540 calls. You could obviously limit your risk by converting the call spread into a butterfly by buying a 530/540 call spread. Alternately, if you wanted to give yourself a wider profit range on the upside, you could buy a 520/530 call spread. Obviously, the drawback is a larger debit. But the net result would be a 520c/530c/540c/550c long condor combined with a 490p/500p bull spread. It goes without saying that, as with all adjustment decisons, what to do would depend on your outlook for the underlying, prevailing vol levels, the deltas et al. of your position and how much time remains to expiry. HD
HD, thank you for the explanation. Do you consider sometimes opening another IC i.e. by opening another spread upside (e.g. 550/560) when the market moves around your upper wing ? Also - looks like you open your defensive spread when the market moves towards upper wing - is there any particular reason for doing this vs. opening when the market hits your short strike of the spread, but not before ? A agree that adjustments depend on many factors and I don`t think there is any formula describing all aspects of this art.
Chris, In the example I gave, the adjustment would actually be made before the underlying reached the short strike (i.e. adjustment is made to protect 540/550 spread when the underlying hit 531+). Delaying the adjustment until the underlying reached the upper wing, and thus neared max loss, would, in my opinion be far too risky. Using some pre-defined technical level for the underlying or delta level for the short strike, provided they trigger before the spread would widen significantly, are reasonable criteria for timing an adjustment. With regard to writing a higher call spread, that's certainly reasonable and is akin to rolling up. However, in my opinion, the first priority should be defending the lower strike spread through the adjustments we've discussed before a new spread is written. Limiting the damage to live another day should be the first order of business whenever a short strike is compromised in one of these positions. Speaking of which, Saddam's capture will no doubt place any such short calls in jeopardy tomorrow morning. What happens after the likely initial gap is anyone's guess. But there will be some scary moments to be sure tomorrow for anyone currently holding short near the money index calls. It should be an interesting session to say the least. HD
HD, I agree, however when the market moves up quickly, corrections are sometimes surprisingly dramatical as well, so building protective positions too soon can bring the exposure to additional risk too early. What is specific about indices that resistance level has been tested for a while and recently seems to be set up for possible move, thus so called "Saddam Gap" might be the spark which can fire the gun.
Here we go. When I trade my dual flies I usually buy back my shorts when market moves and this really gives me big lesson of discipline. In case of today I was ready to protect my upper wing but trained by my experience have waited somewhat longer. Have to say that if you really want to be right most of the time you really have to do the opposite to what others do. Yeah, easy to say
Chris, True. Though one could be tempted to learn another dangerous lesson from a day like today. That is, to hold on come hell or high water to one's short options, despite any pre-defined technical or delta trigger, in the expectation (or hope) that a strong market will reverse in time to bail one out. While I waited until late this morning to cover my short 530 calls, correctly anticipating a gap then fill, I underestimated the extent of the pull-back and, in retrospect, would obviously have been a lot better off waiting until the close or perhaps tomorrow to cover. However, I'm not sure the magnitude of the sell-off was reasonably foreseeable given the underlying strength of the market of late, the positive economic and geopolitical developments and seasonal factors. At least it wasn't to me, though I'm sure there are many on ET now claiming to have called today's action exactly as it unfolded. But continuing to hold the position in violation of my own risk management rules for what seemed a rather remote possibility of a sharp pull-back, particularly after contemplating a pretty bleak outcome yesterday, could arguably be seen as gambling. And, while the gamble would have paid off handsomely for me today, over time, I believe taking such gambles without regard to basic tenets of risk control would be ruinous. Still, at the moment, after having calculated the financial impact of closing the position a few hours early, I find little comfort in the knowledge that I did the "right" thing. HD
HD, I have similar concerns towards the market, so I believe that what was yesterday is not absolutely indicative for the nearest future. I agree that once you set up rules to defend your position they should not be any changed during any market action. I personally work on them in off-market hours and the best, if trading does not keep me busy at the moment. But I feel little uncomfortable in opening protective positions accordingly to the market`s direction. In other words I would rather consider opening them against the direction e.g. call backspreads when market dips down and so on. While I am not certain that this approach is really better, but judging by my experience it might work.
Chris, Well, in retrospect, doing the "right" thing on Monday, ended up in fact being the right thing. Had I not bought back my short 530 calls when I did, the damage would have been immense. Legging out of the spreads, which I don't do very often, also brought some unexpected surprises, as the long calls that I held until this afternoon ended up doing quite nicely. Thus, notwithstanding my momentary regret earlier this week at having missed closing out the calls at the lows by a few hours, I think this experience should serve as a reminder of the critical need to enforce a strict stop-loss discipline when playing with short gamma. HD
HD, That brief scare you had was probably the best thing for you. I'm sure you will work even harder now to manage that short gamma. Consider yourself very fortunate.
Mav, Absolutely. I may have used up 8 of my 9 trading lives with this one. Lesson learned. As a result, I'm inclined to cut back quite a bit on my short gamma exposure next year. I'll also be diversifying across a much larger number of plays per month, which is something I know you've strongly recommended in the past. While I cant say for sure yet that the modified strategy as I envison it will be more profitable, I'm pretty certain it will be a lot less stressful. Hence, a smoother equity curve and more restful nights will be the order of the day for '04. HD