Desperate option positions call for desperate measures

Every good option trading resource says that a trader needs to have a good management plan to avoid big losses. Usually this is followed with vague explanations of setting mental stops and adhering to them. I fully agree with this, except that I believe a trader shouldn’t have vague plans. When an option trader opens a trade, the trader should know what conditions, good or bad, will necessitate an exit. And a system like that will work great until it doesn’t, like maybe during a coronavirus outbreak.

Most of my option strategies involve selling defined risk credit spreads that I enter with many weeks until expiration. My plan is to exit every position 2-3 weeks before expiration, buying back the spread for less than I paid for it. For each strategy, I have a target profit to exit, and a loss limit that I use to get out.

But, sometimes a good plan just fails. What should I do if the market drops 5% overnight and my options strikes were 2% below yesterday’s close? I can wait for a bounce back, which once I’m underwater makes sense if I have time to wait. With my approach, I usually have time. But when a 5% drop becomes 15% or 25%, it’s pretty clear that the odds are I’m not going to see my spread get anywhere close to getting out of the money. This is one of several desperate scenarios I’ve found myself in, not just the past month, but other times as well.

So, what is there to do? Most professionals will say to take the loss and start fresh. If the position is a total loss and hopeless, just leave it until expiration and hope a miracle occurs. All the capital is gone. That’s probably sound advice, and if anyone asks what they should do, that’s what I’d say. But, that’s not always what I do.

Against all advice, and probably all probabilities, I will take a total loss and roll it into something else that has a better chance for success, but increases capital at risk. To repeat, I add even more capital at risk to try and salvage a bad situation, perhaps making a bad situation worse. If that just freaks you out to think about it, just stop reading and move along. Options involve risk, and these approaches might be called risk squared.

If you are nutty enough to still be with me, let me explain. More than most investments, options truly balance risk and reward. Or maybe it is more like a balance between probability of profit and potential reward. Most initial strategies I open have a high probability of profit, but a somewhat limited reward. Those strategies therefore have a dark side, the potential for big losses a small percentage of the time. More often than I should, when those losses happen, I choose to fight to get my money back, because the odds are somewhat switched the other way- I hope to get a big return on the additional capital I add to the position by recovering much of my loss.

Here’s a quick example of a credit/bull put spread. Let’s say I sell a $10 wide spread and collect $1 premium. In real money, I’m risking $1,000 to make $100. Since I collect $100, I’m really only risking the other $900. The odds are probably around 90% that if I hold the spread to expiration, the options will expire worthless. Or I probably have a 95% chance of being able to buy back the spread for $0.50 or less around halfway to expiration. I like those odds. (The odds are actually better, but that’s a different topic.) A few months ago, I did a trade like this over and over, and won 26 times in a row, each time keeping way more than half of what I collected. That’s great, but this post isn’t about the good times, it’s about that 5%, 10%, 20% or whatever percent that things don’t go as planned.

When a trade like the one above has the underlying equity drop in price many times more than the expected move, the position sits at max loss. So, the above $10 spread would sit with a value of $10, a cash value of negative $1,000 in my account. When this happens, it usually happens to a lot of positions at once, even if the portfolio of options is well diversified in every way possible.

Here’s what I do for this situation.

Plan A- get out

First, I try to get out before it gets this far- plan A. In a slow moving market, this is often possible, and I lose something like 1-2 times the premium I collect, but keep over half my capital. When I can, I do this, but there is downside to this practical strategy. Often, underlying prices fluctuate a lot and a position will show a loss, but then turn around for a profit. There is a whole statistic around this, the probability of touch. Read about it in my Greeks section of the website, under Delta. Suffice it to say, if I’m too quick to take a loss, I’ll take more losses than I should. So, the more time I have, the more leeway I give the position to recover. And when there isn’t time, I aggressively get out to preserve capital. In slow moving markets, that works, and it’s the smart trade.

Plan B – wait and see

When the market moves quickly against me and just blows through my strikes, I can continue with plan A and take a bigger loss, but assuming I’ve lost 80-90% + of my capital at risk, there isn’t much capital to preserve. At this point, closing locks in a huge loss to save a small amount of capital, or I can wait and potentially get a big chunk of capital back. Since I trade in a timeframe of several weeks, I like to take time to evaluate the situation. This is a luxury compared to day-trading options that are at expiration. The first question I ask is, how likely is the trade to turn around in the time left on the option contract? If the issue that caused the price drop appears temporary with the possibility of recovering by expiration, then it makes sense to do nothing but wait. If the issue behind the drop is continuing to make the underlying price drop, I will also wait to see how bad it gets before acting, even though that likely guarantees that the position will move to max loss. I wait, and I evaluate options.

Plan C- roll down and widen the position

When a position looks hopeless, I can either give up or do something about it. Generally, there is a way to roll any option position to a new more favorable position and even collect a credit, if more risk is taken on. This may mean converting a $10 wide spread to a $12 wide spread and collecting $0.05, but improving the probability of profit, or more accurately the possibility of profit.

Recently, I had a chance to do this when more than one put spread was blown out by the huge market drop from the coronavirus. Here’s one example. I had sold SPY puts spreads with strikes of 310 and 305 when SPY was trading at over 330 in mid February this year. I like to think of the trade in terms of Delta values. The 310 strike had a Delta of around 18 and the 305 was around 10. That is the sweet spot for me to open a put spread, and I collected $0.75 per share. Expiration was set for late March with a plan to get out in early March. However, the market dropped rapidly, due to the coronavirus, and SPY was well below 300 in a matter of days, and below 275 a week later. By that time, Delta values were between 80 and 90, and the spread was trading between $4.50 and $4.75. I was hopeful that maybe this was temporary, so I waited. When the price of SPY dropped to below $250 on a huge sell-off day, I rolled the spread down to 275 and 267.5 with an April expiration, and collected $0.03, and now increased my capital at risk. I thought more time would allow me to get out, even though my Deltas were still over 75. Unfortunately, the market kept going down. A little over a week later, SPY dropped below 220, and I decided to act again, rolling down to 240 and 230 for another $0.05 credit. Still, Deltas were over 75. Then the market went up, a lot. When SPY went over $250, the Deltas were under 30, and the spread could be bought for $2. I bought it back. In the end, I lost $1.18 premium per share. My original position would have expired a $4.25 loss. I could have rolled out and down again to get a chance at an actual profit by May, but I really wanted to free up capital with the market up. A few other similar positions were rolled down and out further using the freed capital, and maybe they’ll end up a profit. The point is, this position was set up for max loss, and by aggressively converting through a risk-adding roll, the loss was significantly reduced.

A few things I consider when I do this. I try to roll down underwater put spreads on big down days. This may seem counter-intuitive. If I’m at max loss and the market drops more, my position doesn’t actually change much. A $5 wide spread might go from a book value of $4.85 to $4.90 on a $15 underlying drop. I could then roll down the spread $15 for a small debit, or widen the spread to $5.50 or $6 and collect a small credit. I usually play around with different possible rolls, both on the same expiration date and later dates. If I can get more time for not a lot of extra cost or capital risk, that is preferable, since I’m waiting for a recovery.

Indexes vs. Individual Stocks

I also tend to do this more with equity index ETFs than I do with individual stocks. There is a lot of historic examples of markets bouncing back from big drops, even if the bounces are temporary. Individual stocks have more complexity in that they may or may not follow the rest of the market and have their own unique issues that drive their price in unique ways. My goal in a desperate situation is to use big declines in market value to reposition my option spreads to be able to get out of the money when a bounce occurs. I’ve just found that indexes are more likely to accommodate that strategy.

Spreads partially in the money

I want to differentiate between a spread that is fully in the money and one that is partially in the money. When I have a credit spread where both the short and long options are in the money, then I’m fully in the money, and max loss is a real possibility. When only the short option is in the money, but the long is still out of the money, I’m likely only sitting with a premium value of around half the width of the spread- $2.50 for a $5 wide spread, so the position is partially in the money. When a position is partially in the money, I have a couple of active choices, close before I lose the other half, or roll out for additional time and a credit. If the underlying price is actually closer to the short strike than the long, I can almost always roll out to a later expiration date with the same strike prices for a credit, and I may be able to roll down or narrow the width for less credit. The point is there are more positive choices that don’t add capital risk when a spread position is only partially in the money.

Naked put considerations

I also want to point out that these types or rolls are for credit put spreads, not naked puts. If you sold a naked put and you are in the money, the only choice available to avoid a loss is to roll out in time. The good news is that it is almost always possible to roll to the same strike price at a later date and collect a credit, something that isn’t true with a spread. The bad news is that there aren’t really any other choices. A naked put has undefined risk, and if the underlying price keeps dropping, the losses keep adding on.

Reverse an early assignment

When positions get deep in the money, the risk of early assignment grows. Assignment is when an option buyer exercises the option before expiration. Since we are talking about market downturns in this post, this is when a put buyer makes a seller buy the underlying security. Because I try to close or roll positions well before expiration, I don’t get assignments very often. But it can happen, and when it happened the first few times, it can be very troubling. I woke up one day and found that I had bought $500,000 of SPY, and also had an accompanying -$500,000 cash balance due. Before panicking, remember that a spread has an equal amount of long contracts to the amount of contracts that were assigned. If I had 20 short contracts assigned into 2,000 shares, I also had 20 long contracts still sitting in my account. When I get an early assignment, it usually means I get a negative cash balance in my account, and I can’t make any other trades until the assignment is adjusted in some way. There are a number of choices on how to get out of this and either not lose any more, or even reverse the situation and roll into a position to get some of the losses back.

The simplest thing to do would be to just sell the shares, which would likely get the cash balance back positive, and eliminate all the new shares. However, if the assigned shares are sold by themselves, the link between their value and the long options hedging them is broken. What link am I talking about, you may ask?- I don’t have a spread anymore, I have shares and long options. The link is that the shares were bought at the short option strike price. Let’s say I have a $5 wide spread, short a $250 strike put, and long a $245 strike put. If one contract is assigned, I buy 100 shares for a total of $25,000. But the assignment was because the underlying security was trading for less, say $225 a share. If I sell the shares at the market, I’ll only get $22,500 for them, a loss of $25 a share. Didn’t I buy a $245 put for some reason to help with this?

Another transaction I could do would be to sell both the shares and long put at the same time. Most likely both are well in the money. If that is the case, I could sell the combination and lose no more than the difference in strike prices. In my example above, I would make at least $24,500 to sell the combination of shares, because the long option price would be relative to the underlying price. For example, if the underlying price is $220, the long option would be worth $25, and the sale of the combination would be $245 per share, or $24,500 cash. If the underlying price was closer to the strike price, the sale might make a little more if there is time value in the long option.

My experience is that puts that are exercised early usually are exercised at very near the low of whatever is going on, say after a day when the market was just devastated. If the shares are sold alone and the long put is held onto, the market is more likely to go up and eat away the value of the long puts, which locks in the oversize loss. I’ve done it myself, but I don’t do it anymore. Instead, I look for ways to reset my position without losing a hedge.

An easy way to reset the position that was in place before an assignment is just undo the assignment- sell the shares and sell the same put that was assigned. So, if a $250 strike short put was assigned, just sell the assigned shares and re-sell the $250 strike short put. Likely, the sales price will be just under $250 per share total, maybe $249.90- just under due to the bid-ask spreads of each leg and any remaining time value in the option being sold. For example if the underlying was trading at $220, the shares would well for $220 and the $250 strike option would sell for just under $30, at total of just under $250. So, the total cash received would be just less than the $25,000 that was required to buy the shares. And we’d basically be back to where we started before the assignment, less a tiny amount of pricing spread and maybe some time value in the option. The problem is that since shares were assigned the previous night, they might be assigned again the next night, and the we’ll be right back in this mess again.

Here’s one more choice- let’s reverse our position at a different price and different expiration, a four legged trade. Some brokers allow this to be done as one trade, but most will require this to be done in at least two separate trades, which is fine. The plan is to sell the newly assigned shares with the remaining long put, and then open up a new spread that is more favorable, like we could have if the short option hadn’t been assigned. Using the example, we’ve been using with our $250/$245 spread with the $250 short strike assigned to us, we’d sell the shares and the $245 strike long put for about $245 a share, or a total of $24,500 cash. Then we sell a new put spread closer to the money, and maybe a bit wider to collect a $5 or more credit per share or $500 total per contract. After all that, we have a position more likely to get out of the money with more time, albeit with a bit more capital at risk.

Conclusion

So, when the market trashes a put spread, there are ways to recover, even if there is an early assignment. I try to pick the least bad of several terrible choices. Some ways are more complicated than others, but desperate positions may lead to desperate measures.

Final disclaimer- this information is just information, and not my advice. Trading options involve significant risk, often multiple times the value of the initial trade, and every trader has to understand and consider the risk of a trade for themselves. Every situation is different, and there is no correct answer for every situation. Adding addition capital to a lost position can likely lead to loss of that capital as well.