Three Options Trading Adjustment Strategies

With all the information that's out there about how to enter an options trade, there's usually not as much focus on how to get out. Whether you're winning or losing, and unless your plan is to hold an options position until expiration, at some point, you do need to exit to take a profit or chalk up a loss. There are many options strategies to cover on this subject, but in this article, let's focus on three of the most popular strategies to "adjust" an options trade: long options, vertical spreads, and calendar spreads.

Whatever your reason for needing to make an adjustment—exiting at a profit or a loss—understand that the adjusted trade isn't the same trade you put on. Here are three things to consider:

1. Treat any options trading adjustment as a new position. Map profit and loss exits as you would for any new trade.

2. Match your new position with your market outlook and volatility backdrop.

3. Consider carefully any adjustments that add risk to the original trade.

You're a believer in XYZ Corp., and you bought 10 contracts of the September 50-strike call for $1, for an initial investment of $1,000 plus transaction fees. (For each example, remember to multiply the options premium by 100, the multiplier for standard U.S. equity options contracts. So, an options premium of $1 is really $100 per contract.) Now the call price has doubled to $2. You can't be blamed for wanting to take the money and run, but you're as bullish as ever and don't want to miss out. Here are three hypothetical scenarios.

One idea is to sell at least enough contracts to bring in more money than your initial debit. For instance, selling six of the call contracts that now trade for $2 would net a credit of $1,200 minus transaction fees. This way, you're locking in a certain price gain, even if the remaining part of the trade fizzles.

Another possible strategy might be to turn your long calls into a vertical call spread by selling 10 call options contracts with a higher strike. For example, with the stock at $52.50, you could sell the 55-strike calls for $0.80 minus transaction fees. Even though this adds a short call to your account, you now own the 50–55 call spread, which has a total risk of only $0.20 per contract. That's calculated by taking the initial $1 cost of the 50-strike calls minus the $0.80 credit from selling the 55-strike calls. If XYZ drops below $50, and the spread expires worthless, the loss is limited to only $0.20 rather than your full $1. The trade-off, of course, is that vertical spreads limit the upside potential of your short strike, the 55-strike, whereas a single long call option can continue higher if the underlying stock price rises above $55. And keep in mind that a spread comes with transaction fees, which negatively impact potential returns. Additionally, spreads are only available in qualified accounts.

If the stock climbs above $55 and this spread finishes fully in the money (ITM) at expiration, you'll realize the $5 max value per spread minus transaction fees and the $0.20 debit for the spread. However, it's also possible that you might want to close the spread for a profit or loss before expiration. If your bullish outlook has changed, for example, you might close the position entirely by selling all 10 of the 50-55 long vertical call spreads.

If the 50-strike call is ITM and the 55-strike call is out-of-the-money (OTM) at expiration, the ITM call will be subject to automatic exercise and the OTM call will likely expire worthless. Carrying options into expiration can entail additional risks; for example, an unanticipated exercise/assignment event could occur, or an anticipated event may fail to occur. In the 50–55 call spread example, the short call option could be assigned at $55 per share at any time, especially if it is ITM and near expiration (or the underlying stock is going ex-dividend.)

Keep in mind, if your long option is ITM at expiration but your account doesn't have enough money to support the resulting long stock, your broker may, at its discretion, choose not to exercise the option. This is known as do not exercise (DNE), and any gain you may have realized by exercising the option will be lost. DNEs can be submitted by any option holder and instruct the broker not to auto-exercise ITM options at expiration. A broker may also, at its discretion, close out (sell) the options without prior notice.

Cash out the long call that's made money but stay in the game by "rolling up," which can sometimes be accomplished by executing a short vertical spread to adjust the long call to a higher strike. In this example, the adjustment might involve selling-to-close the 50-strike calls and buying-to-open the further OTM calls. Rolling to a higher strike call from a lower strike call will likely net you a credit that reduces the trade's overall risk.

Bonus: If the credit's more than you originally paid, you've locked in a profit. And remember, the new order carries transaction fees, which can affect potential returns.

Sticking with XYZ, let's now assume you originally bought one 50-strike call and sold one 55-strike call as a spread for $0.80 plus transaction fees. You could consider spreading off the trade or rolling it up.

A long call butterfly spread combines two call spreads (a long vertical and a short vertical), all with the same expiration dates. Traders typically create the spread by buying a lower strike call option, selling twice as many of a higher strike call option, and buying a consecutive higher strike call. The standard butterfly has three strike prices that are equidistant.

For example, if you already bought the 50–55 call spread to open a long vertical, the options trader might create a call butterfly spread by adding the 55–60 short vertical call spread. In the new spread, the two short 55-strike call options represent the middle or "body" of the butterfly spread, and the long 50- and 60-strike call options are the "wings." The best-case scenario for the spread happens if the stock is at $55 per share at expiration. At that point, the 50-55 long call spread has reached a maximum value of $5 per spread and, ideally, the 55-60 strike short call spread will expire worthless.

Keep in mind, however, that carrying two short options into expiration can result in an unwanted assignment situation and a short stock position, especially if the stock is at or near the strike of the short calls ($55) but below the higher strike ($60) long call. Early assignment before expiration is also a possibility, and a short call is more likely to be assigned early if it is ITM and/or the underlying stock is going ex-dividend.

If you adjust the long call spread to a call butterfly spread, calculate your new risk by subtracting the credit from this adjustment from the initial debit. For example, if you bought the 50-55 call spread for $0.80 with the stock at $52.50 and shares are now $55, then the 55-60 call spread is sold at $0.50 to create a long call butterfly spread, the theoretical risk is now the net debit of $0.30. This calculation excludes any risk that may occur with early assignment.

If the stock falls back below $50 and the position is left open through expiration, the options will typically expire worthless, and the net debt is lost. On the other hand, if the stock is above $60 and the long calls are exercised to cover the short calls, the long and short positions offset, resulting in a loss equal to the net debit. Sometimes, exercise and assignment is the optimal way to exit a butterfly spread, but traders often exit their positions early to eliminate exercise and assignment risk that can occur when expiring options are ITM or nearly ITM.

The idea behind rolling up a vertical is the same as rolling up a single option: Take profits on the original trade, then do the spread again at higher strike prices. For example, selling the 50–55–60 call butterfly (selling one 50-strike call, buying two 55 strike calls, and selling one 60-strike call) rolls the spread to higher strike prices because it closes the 50-55 long vertical call spread and opens a 55-60 long vertical call spread. Subtracting the butterfly credit from the original debit leaves you with the remaining net risk of your new 55–60 call spread (see table below).

Roll a vertical spread to higher strikes to take profits on the original trade and then use those profits to try it again.

Which adjustment do you make? Ask yourself which position you'd enter if this was a new trade. Why? Because it is a new trade. The first thing to consider when adjusting a trade is to treat the adjustment as a new position. Have profit and loss exits mapped out as you would for any new trade.

There's nothing better than having a successful trade when a stock trends sideways, which is what calendar spreads are designed to do. Constructing a calendar with a little time between the long and short options may give you the opportunity to roll the short option. Once the short option has lost a significant amount of its time value, consider selling a calendar spread to close the short option and sell the same strike option at the next expiration.

Losing trades are an expected part of trading. Sometimes, simply closing the trade is the right decision. Other times, it might be appropriate to do something else. The assumption here, though, is that you're managing this losing trade before it gets out of hand.

Your long call position has eroded in time value because XYZ stock hasn't budged. But you still believe the stock is poised to move higher. In the meantime, to attempt to salvage some of what's left while still leaving yourself a chance for some profit, consider converting your call to a spread.

Just like with the winning trade, sell a higher-strike call in the same month. Deduct the credit from the original cost of your long call to arrive at the net debit of your trade. The second rule of adjusting trades applies: Match your new position with your market outlook. Because you're still bullish on XYZ, it might make sense to maintain a bullish trade. But it's best to do the math. If there's not much premium left in the higher-strike option, it might be best to close out the trade and move on. Remember: Additional trades mean additional transaction fees. Also, be aware that if the long call is ITM at expiration, it will be subject to automatic exercise and result in a long stock position.

If there's enough time left in your long call, another idea might be to convert your position into a calendar by selling a shorter-term call with the same strike. This "buys" you some time for the stock to get going. And while you're waiting, the short option might hedge time decay risk (and potentially some of the downside risk) of holding a long call. If XYZ comes back to life, you may be able to buy back the short option to return to your original trade. When assessing the strategy, remember to include the profit and loss, plus the added transaction fees, of the shorter-term strike you sold and bought.

Of course, converting to a vertical spread isn't a choice if that's what you started with. But all is not lost. One possibility when faced with a losing vertical is to roll the entire spread further out in time and to a later expiration month. Consider avoiding a net debit on the trade. That violates the third consideration of adjusting: Don't make any adjustments that add risk to your trade. To avoid adding risk, you'll have to roll up the spread to strikes that are further OTM than the current spread. This may not be ideal, but the longer time horizon might give your trade time to work.

Similar to winning calendars, rolling out the short strike might reduce the risk in the trade. But because calendars often work best with at-the-money (ATM) options, if the market moves, you might have to move with it. Rolling a calendar that's gone ITM will cost you. But here's how you might get around that.

Roll the long option up/down in the same month to the ATM strike. Then, roll the short option up/down to the same strike, going one expiration out in time. If the net cost of both trades is a credit, it might be a worthwhile adjustment. If it's a net debit, it might be best to exit.

With any options strategy, simply winning or losing doesn't mean you need to close your trade, although that'll sometimes be the best choice. When you have a reason to stay in, adjusting a trade can help you cut risk, take money off the table, and give you time to make more plans.