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Wednesday, March 7, 2012

How to adjust or roll a Credit Spread

XYZ is trading at $100, 30 days to expiration. You play a Credit Call Spread selling the 110 Call and buying the 115 Call for protection. The goal is for XYZ to not hit $110 by expiration. Let's assume that a credit of $2.00 is obtained (that is $200 per contract per leg played).

10 days later XYZ is trading at $109, certainly threatening your position and you have a temporary loss of $100. With 20 days to expiration it seems very likely that XYZ can advance one more point to the upside. At this point you can close your trade for a small loss. You can also hope for the best and wait for XYZ to reverse (hope is never the best decision), or you can adjust your position.

In order to adjust your Credit Spread you have to close it by buying back the 110 strike Call, and Selling to close the 115 strike Call while at the same that time you open a new Credit Spread at higher strike prices. Let's say you now sell a 113 Call and buy a 118 Call for $1.80 credit.

As a result, you have a partial loss on the Credit Spread that was closed but you are on a new position where your strike prices are much less threatened. Plus the new credit obtained can offset the initial loss if this second position turns out to be a winner. You have adjusted your credit spread opening a new one on the same expiration month.

Same or next month?

Now, here's the key. If the second position you open, (the adjusted one) offers too small  a credit, you are probably either too out of the money or too close to expiration. You wanna get a credit that is substantially bigger than the initial loss and the commissions charged, in order to make it worth it. Being close to expiration, perhaps less than 20 days, means there is small time premium to sell on this month's options, so potential rewards are not that juicy anymore.

In this case you can open your new position using next month's options. This is what is called a Roll Over. You have rolled your position over to the next month, in order to obtain a more juicy credit for your adjustment.

In my humble opinion it is preferable to be able to adjust in the same expiration cycle (month) of the threatened position, so you can get your winner trade faster and get out of the mess sooner. But, at times you might be forced to go and Roll over into the next month if the new credit received just doesn't cover trading costs plus the initial partial loss.

Disadvantages

Obviously this adjustments and/or rolls are commission intense. You definitely need an options friendly broker other wise commissions will eat you alive. The second disadvantage is that usually, after the adjustment or roll is made, your new profit picture looks less attractive, meaning less reward and potentially higher maximum risk. But this is all in order to give your self some time and hopefully be able to offset your initially threatened position before you get to the worst case scenario of a 100% loss on a trade.

During my training journey so far, I made one adjustment already on a SPY  position back in November which you can check out here. On a final note, although adjustments on a Credit Call spread were explained, this obviously applies to Credit Bull Put Spreads as well.


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