With numerous occurrences in our portfolio, we know that some trades simply won't go our way.
Fortunately, if we’re using a high-probability approach, the number of losing trades will be smaller than the number of winning ones. However, given that losing trades are a "known known," planning for this eventuality makes for smart portfolio management.
We know a small percentage of the trades in our portfolio will get tested at one point or another, so what preparations can we make ahead of time?
If you're looking for some guidelines to help you play defense, particularly as it relates to short premium exposures, a recent episode Options Jive is worth a few moments of your time.
At tastytrade, we often use the word "tested" to refer to trades in which the underlying breaks through our short strike or break-even price. “Tested” might also be defined as any point in the trade cycle at which you become uncomfortable with the associated risk of the position.
In this installment of Options Jive, the hosts review some tactics traders can employ to limit the damage when a position gets tested.
At a high level, traders have three choices when combating troubled positions:
Close the position and take the loss
Hold the position
Roll the position (expiration, strike, or both)
The first bullet point above is fairly straightforward - if you can't accept the risk associated with a given position you can always close it, take the loss, and move on. This can be particularly useful if your outlook on a given position changes due to news development, or some other factor.
For example, imagine you were short the $21 strike puts in the RSX (Russia ETF) prior to the recent chemical attack in Syria. In the wake of that international incident, it was rumored that the United States might further sanction the Russian government for their involvement in this tragedy.
As a result of the perceived impairment to the Russian economy by further sanctions, the RSX cratered from $22 to $20 in a day. At this point, the trader holding the (now painful) short $21 strike puts had three choices, as outlined in the bullet points above.
If the trader could no longer accept the risk associated with the position, he/she might have decided to close the position immediately and take the loss. If you can't stand the risk, that's actually the only choice.
On the other hand, the trader may have decided to hold the position through expiration, and consequently fully accept additional potential losses. In this hypothetical case, the decision to be patient with the position worked out to some degree.
After the United States responded to the chemical weapons attack by bombing government-held positions in Syria, President Trump announced that he would defer further sanctions against Russia (for the time being). The *RSX has since rallied back above $21/share - a win for our hypothetical trader that decided to hold the position.
The third choice open to that trader would have been to roll the position - meaning buy in the short puts in the nearer-term expiration in favor of selling puts in a longer-term expiration. The trader also could have switched to a new short strike in the later expiration, depending on his/her outlook and risk tolerance.
Rolling is a modified version of holding the position; basically extending the time to expiration and giving the position more time to work. This decision would only be selected if the trader believed their original reason for taking on the exposure was still valid.
Holding a position and rolling both rely on the premise that "patience" in volatility trading is a golden virtue. Previously, we've highlighted tastytrade research which demonstrates the power of patience, and we recommend reviewing that material in conjunction with today's post.
As you can see with our hypothetical position in RSX, traders have a variety of choices when a position moves against them. On the aforementioned episode of Options Jive, the team lays out some guidelines and tactics related specifically to rolling (bullet point 3).
Due to the importance of this topic, we recommend reviewing the complete installment of Options Jive when your schedule allows. This information should help you better understand the choices available to anyone theoretically holding the RSX position (or one like it) and considering a roll.
If you have any questions about defending losing trades, or anything else, we hope you'll leave a message in the space below, or reach out directly at email@example.com.
We look forward to hearing from you!
*Note - The RSX trade was included as an example for illustrative purposes. The RSX will likely have moved lower or higher in the time between the completion of this post and its publication.
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.