Even the most experienced traders have trades that go against them for one reason or another. So, let’s look at how to manage a trade that went against us.
Typically, we are not big proponents of managing defined risk trades like iron condors or spreads. We know the risk on these trades heading into them and we’re comfortable with the maximum possible loss. Undefined risk trades such as strangles or naked puts or calls, are a different story.
There are some strategies we use when managing trades gone awry. One of our favorite trades, selling a strangle, is selling a put and call around the expected move in a stock. Let’s walk through how we manage a strangle if it goes against us.
One of the beauties of selling both puts and calls is half the trade has to be right. If the puts are in trouble, the calls are safe. If the calls are in trouble, the puts are safe.
If a stock moves through an option we are short, we immediately buy back the other half of the trade that isn’t in trouble. For instance, if a stock moves lower than expected, we buy back our call, turn around and sell another call, closer to where the stock is trading. If the stock moves higher than expected, we buy back our put and sell a new put with a higher strike price. At tastytrade, we call this “rolling up” or “rolling down” depending on if we are talking about the call side or put side.
Rolling allows us to collect additional premium. This is important for two reasons:
First, if we have to buy back anything, we’ve reduced what it will cost.
Second, if we are eventually assigned stock on a short option (i.e., long stock from a short put, short stock from a short call) the premium collected is lowering our cost basis.
For the side of the trade in trouble or “being challenged,” ideally we want to “roll it out” to a further expiration or further OTM strike for yet more premium. That means buying back the challenged option then selling the same type of option (i.e., put or call), further out of the money and likely further out in time.
The reason we have to go further out in time is often that is the only way to collect enough premium. As a general rule, we only roll for a credit or if rolling will not cost us anything. If rolling involves a debit, our preference is not to roll.
Not all trades can be managed neatly. There are a number of variables that can affect our ability to manage trades from account type to account size. But for those trades we can manage, this is our preferred method.
Josh Fabian has been trading futures and derivatives for more than 25 years.
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