Although I personally do not like using the word “adjustments” with options trading (I prefer new outlook), there are many times they need to be done. Adjusting option positions is an essential skill for options traders. Adjusting options positions helps traders repair strategies that have gone wrong (or are beginning to go wrong) and often turn losers into winners. Given that, it’s easy to see why it’s important to learn to adjust options positions.
Adjusting options positions is a technique in which a trader simply alters an existing options position to create a fundamentally different position. Traders are motivated to adjust options positions when the market physiology changes and the original trade no longer reflects the trader’s thesis. There is one golden rule of trading: ALWAYS make sure your position reflects your outlook.
This seems like a very obvious rule. And at the onset of any trade, it is. If I’m bullish, I’m going to take a positive delta position. If I think a stock will be range-bound, I’d take a close-to-zero delta trade that has positive theta to profit from sideways movement as time passes. But the problem is gamma. Gamma is the fly in the ointment of option trading.
Gamma—particularly negative gamma—is the cause of the need for adjusting.
Gamma definition: Gamma is the rate of change of an option’s (or option position’s) delta relative to a change in the underling.
Oh, yeah. And, just in case you forgot…
Delta definition: Delta is the rate of change on an option’s (or option position’s) price relative to a change in the underlying.
In the case of negative gamma, trader’s deltas always change the wrong way. When the underlying moves higher, the trader gets shorter delta (and loses money at an increasing rate). When the underlying moves lower, negative gamma makes deltas longer (again, causing the trader to lose money at an increasing rate).
Option traders must learn to adjust options positions, especially income trades, in order to stave off adverse deltas created by the negative gamma that accompanies income trades. Once an option trader has a good grip on what changes need to be made based on his or her new outlook, potential profit can be an adjustment away!
Senior Options Instructor