Avoid Over-Adjusting Option Delta

Earlier this week, I decided to go all in on adjusting the Delta of my option portfolio. Monday, to be specific, I moved from a somewhat positive portfolio Delta to a very negative portfolio Delta. In hindsight, this was a bad move for a variety of reasons, and I thought it was worth writing a post to share.

Background

For those of you new to option Greeks, Delta is the option parameter that measures how much a underlying security price change will change the price of the option. If a stock goes up $1, how much will the option price change? For every position in your portfolio, you can measure this impact, and with a little math, you can figure this out for your whole portfolio. The key is to price weight the Delta values so that different priced stocks and ETFs are weighted proportionally to their impact on the portfolio. There is a whole section on Greeks on this site that goes into the particulars if you need more information. There is also an overview of Delta included. However, it isn’t necessary for you to fully grasp all the theory to understand the point of this post.

Before my changes, my portfolio moved about half the amount on a percentage basis as the market moved in the same direction- if the market went up 1%, my portfolio went up 0.5%. After the change, my portfolio moves two times the market in the opposite direction- if the market goes down 1%, my portfolio goes up 2%.

Why did I do this, you might ask? Well, the market has gone nowhere but up for the past three months, and is due for a reversal. It is up so much that I saw in the weekend Barrons publication that one indicator says we reached “Euphoria” levels this past week, which says we are likely to be lower a year from now. Also, the coronavirus was in the news and could have a big impact on the global economy. Last week the market was down for the first time in three months, and we had all four days close at a loss. (The market was closed Monday for MLK day.)

Over the weekend, I decided I was positioned the wrong way- my portfolio was positive Delta and all indications were that the market was going down. And Monday, the market opened way down, over a percent and a half lower than the close on Friday. My portfolio showed a loss of just under 1% for the day. If this is what we are going to see for the next several weeks, I needed to get positioned to profit.

If you aren’t familiar with my approach to option trading, I’m a big proponent of defined risk credit positions. In other words I sell options spreads for a premium and then expect them to decay in value so I can buy the spreads back for much less than I sold them for. I sell both put spreads and call spreads, often on the same underlying security on the same expiration, an Iron Condor. Typically, I try to be Delta neutral (price neutral), so I benefit whether the market goes up or down, but mainly when it doesn’t move very far in either direction. But for three months the market has gone up- a bunch! The call spreads of my Iron Condor were getting breached and were losing money. It is no fun to lose money when the market is going up.

To adjust for the very bullish market, I’ve started selling many more put spreads and call back spreads for the last month or so. I stopped opening new Iron Condor positions. I have several put spreads without calls. These positions benefit when the market goes up more than when the market goes down. The Delta value of these new positions are all positive. That was working well with the market climbing almost every day, and profits were rolling in. Then last week the market turned….

Monday’s adjustment

So, what did I do? Since my read was that the market was at the beginning of a downturn, I wanted to reverse how my options behaved. I went through my positions and closed out every put spread that is expiring in the next four weeks. If I had opened them several weeks ago, I could close them at a profit. However, if they were recently added, I had to take a loss, especially on Monday with the market down, when puts are more expensive.

I also converted many of my call backspreads to simple credit call spreads. If you aren’t familiar, a call backspread is when you sell one call and buy two calls further out of the money. I often buy the two calls at just less than half the Delta of the call I sold, and can collect a credit. If the market goes up a lot, the two calls I bought become worth more than the call I sold. But if the market goes down, the long calls quickly drop in value. On several backspreads I had, I sold one of the long calls that I had bought. I took a loss on each of them, but I thought they were going to soon be worthless with the market going down, so it made sense to sell. The remaining spread of one short call and one long call could then decay in my favor when the market tanks.

Why do I think this was wrong?

Tuesday, the market went up 1%, and I lost a little over 2%, because of the changes I made. So, I lost on an down day on Monday because I had positive Delta, and I lost on an up day on Tuesday because I then had negative Delta.

I still think we are likely to see a down market over the next month, and I think my position will eventually benefit. But, my approach to adjusting was wrong on several fronts. Generally, my timing was terrible and the magnitude of the change was too much at once. Here are the key principles I violated.

1. I closed into weakness and not into strength.
2. I made too big of an adjustment at once.
3. I should have known the odds were against me on Monday.
4. I didn’t pay attention to how much Delta I reduced

Let’s take these one by one.

Closing into weakness

Everyone knows that the goal of trading anything is to “Buy Low and Sell High.” For an option seller, it is actually to “Sell High and Buy Back Low,” but the idea is the same. When you have a short put position (or a credit put spread), the best time to buy it back is on a day when the market is up and it is less valuable. In a choppy market with the market up one day and down the next, picking the right day to open and close positions makes a big difference.

The same is true of selling a long call position- sell calls on an up day when the call is most valuable.

Not only was the market down the day that I closed my short puts and long calls, it was down the largest amount that it had dropped in three months! A terrible day to make this change. I paid way too much for my puts, and I received way too little for my calls.

Too big of an adjustment at once

As I already said, I think the market is still headed down over the next several weeks and I think negative Delta will do well. However, I might be wrong, and I pride myself on avoiding big directional bets.

I moved to a portfolio Delta that is negative twice the value of my portfolio. If your broker provides a SPY-weighted Delta measure, you can see this by multiplying your SPY weighted Delta times the value of a share of the SPY ETF. As an example, if you have a SPY-weighted Delta of -100, it is equivalent to being short 100 shares of SPY. At today’s SPY price of $327 per share, the portfolio will behave like negative $32,700 of SPY shares. If your portfolio had a dollar value of $16,000, you would lose 2% if the market went up 1%. That’s essentially my new position.

So, what would have been a better approach? Well, if I was absolutely determined to adjust my portfolio Delta on a down day, I could have adjusted just until my Delta was zero. Then, when there was an up day in the market, I could have adjusted into negative delta territory.

In any case, moving from a Delta value that is 0.5x my portfolio value to one that is -2x is too far, too fast. I’ll be looking for a chance to work myself back closer to Delta neutral in coming days, even if I stay with negative Delta.

Odds were against me

There were at least two predictors that I should have paid attention to on Monday before making the changes I did. I should have known that it was very likely the market would go up on Tuesday, making Tuesday a much better day to adjust than Monday. As it turned out, the market was up 1% Tuesday, the largest up move in three months.

How would I have predicted this? The first reason is a bit weak, but often true market myth- Tuesdays generally bounce the opposite direction of Monday. This is the kind of story that I tend to doubt, but many market veterans quote it every time it happens. For me, it is one piece of information to consider, but especially after a big move on Monday.

The second reason is more data-based. The most losing days in a row we have had in the past 20 years is six. It has happened only a few times, but we have not had seven losing days in a row in the past 20 years. How do I know this? Tasty Trade did a study on this last year and it stuck with me. You can see it yourself in this segment on Fading Market Moves. Monday was the fifth losing day in a row. It is very rare for there to be six losing days in a row, so the end was in sight and I attacked too soon.

There are other reasons to reconsider timing, especially on down days. We generally have more up days than down, so unless the situation is critical, there is usually a better time to reduce your bullish position than on the biggest down day in months.

If the opposite situation were true, I’d feel a little different. The market can have very long winning streaks, and you really can’t wait for a down period to fix a bearish situation.

Not knowing the number

When you run a website called Data Driven Options, you should know the Delta impact of the changes you make. I trade on a platform that doesn’t offer a weighted Delta measure, so I export a list of positions at the end of every day and calculate my portfolio delta on a spreadsheet. There has to be a better way, and I think my broker will soon offer a real-time solution, but for now, I’m flying a little blind when I make a lot of changes in a single day.

That’s really no excuse. Knowing what I wanted to do, I should have looked at the total weighted Delta values of the positions I was closing and determined the impact. I honestly didn’t think I had shed that much Delta while I was doing it. I’ll be more aware next time.

What to do after messing up

I can’t go back in time and get my Monday and Tuesday losses back. To be fair, this is far from an insurmountable loss. However, I can learn from my mistakes and share what I have learned.

The other thing I can do is to adjust portfolio Delta back toward neutral. I still want to be negative for at least a few weeks, just not this negative. To do this, I’ll start selling put spreads, especially if we have some big down days soon. Otherwise, I’ll chip away slowly. Ideally, I’d like to get my SPY weighted Delta to a value equal to between -0.5 and -1.0 times my portfolio dollar value soon. Then if we see a correction, I’ll look for an opportunity to move more closer to a zero Delta position. A slight negative Delta is generally best for option positions, because volatility changes will then cancel out underlying price moves in either direction.

Conclusion

When you are trading options, a key metric is portfolio Delta. As market prices change over time, a major consideration of what types of option positions to open and close are those that move your portfolio Delta to a more desirable value in line with your market outlook. For traders like me, this usually means moving toward zero or neutral Delta.

When changing your portfolio to adjust Delta, timing and the amount of change can’t be ignored. Over-adjustment at the wrong time puts a portfolio at risk. I know, because I just did it myself.