Adjusting Losing Trades: Four Scenarios

Let's say you have a losing trade, but you don't want to close it out. Maybe it's a single long option. Or maybe it's just stock. What can you do? If you're trying to adjust a losing trade, don't wait until there's nothing left to fix.

Before attempting to adjust a losing trade, you need to understand you're not really fixing a broken trade. The loss is real, and any sort of adjustment begins a new trade. So, when faced with a similar situation, ask yourself, "Does my original analysis still hold, and would it be better to adjust my position or exit the trade and move on?"

Consider these four common scenarios and potential strategies to adjust a losing position. Keep in mind, this isn't an exhaustive list of possible position adjustments, and the examples are intended to illustrate potential follow-up actions, which will likely vary depending on the strategy and the trader's forecast for the underlying stock.

The situation: If you bought stock at the wrong time, it might be the right time to introduce yourself to the short call option. By selling a call option, you're giving someone else the right to buy the stock at a fixed price (the strike price). That means you're obligated to sell the stock if the buyer decides to exercise their right. So, choose your strike price carefully. In exchange for this obligation, you'll collect the premium from the trade, minus transaction fees, and the premium reduces your break-even point. 

Let's look at an example. Suppose you bought 100 shares of stock at $85, and it promptly moved lower to $80.

The adjustment: Using the options prices (see below), you could, for example, sell one 85-strike call for $1.30 or a total of $130 because the multiplier for a standard option is 100. Subtracting $1.30 of premium from your stock purchase price of $85, leaves you with a break-even price of $83.70. And, once you've sold the call against your long stock, you now hold a "covered call," which is a strategy some traders use to generate income.
 

If the stock remains below $85 through expiration, then your option will likely expire worthless, and you can hold the stock alone. Or you can choose to sell another call to move your break-even price even lower. 

However, if the stock moves towards $85 or beyond prior to or at expiration, assignment becomes a possible outcome. Once a trader receives an assignment notice, it's too late to close the position and the stock will be called away for $85. Let's examine a couple of scenarios.

• One: Depending on the days left until expiration, and how high the stock goes, you might be able to buy back and close the call option at a lower price than you sold it. That would be a win-win because you made a profit on the call and have a gain in shares. However, if you buy the call to close at a price greater than the initial premium, you'll realize a loss on the call option. 
• Two: You might get assigned— that indicates, in this case, you have sold your stock. Keep in mind, assignment can happen at any time prior to expiration regardless of where the stock price is relative to the strike, and once assigned, it's too late to close the call—you're required to deliver 100 shares per call option. Your stock was sold at $85, which in this example is the price you bought it for anyway. And you get to keep the $1.30 premium minus transaction fees.

The potential result: You don't increase your risk by selling the call option. You're lowering a break-even point and giving up the potential profit above the call's strike price at the same time. But, if you don't want to lose shares, you may not want to use this strategy. Should you decide to use this strategy, be prepared to buy the call to close it out.

The situation: Long calls and long puts can be successful when the underlying stock is moving in the right direction. But what if the stock takes a break or even starts to move against you? Or if these or some other factors cause the implied volatility¹ of the option to drop?

The adjustment: One possible way to adjust a losing long call or long put is to convert it into a vertical spread by selling another option that's further out of the money² (OTM) than the option you own but in the same expiration. This turns your long option into a long vertical spread (see below). The premium from the sale of the further OTM option lowers the trade's overall debit by the premium you collected, but it will also limit the potential profit on the position. Keep in mind, to modify a single option to a spread, a trader's account must be approved for option spreads and margin.

The potential result: A few good things can happen. First, the premium from the short call or short put reduces the total risk. Second, your trade should now be able to withstand a greater reversal in the stock's price or a drop in implied volatility. Finally, your trade might still profit if the stock once again moves in the desired direction. The risk of the spread is the net premium paid and the potential reward is the difference between the two strike prices minus the debit, excluding transaction fees. Note that an unexpected assignment or exercise situation and subsequent moves in the underlying stock can change the risks and rewards.

The situation: If it's a short put position that's moving against you, either the stock is moving lower, implied volatility is ticking higher, or possibly a little of both. Depending on your forecast, you might choose to sell an at-the-money (ATM) or OTM call vertical spread to offset some of the short put's loss. The short put is a bullish trade. But selling a call spread is a bearish trade.

The adjustment: If you think selling the call spread is a good idea because you believe the stock will keep moving lower, you might want to close the original short put. Selling a short-term call vertical and holding the short put might be a worthwhile adjustment when the underlying stock is expected to stay above the strike price of the short put but below the strike price of the short call through the expiration. The premium collected from the call spread is added to the premium from the put. At expiration, if the stock is above your short put, but below the strike of the short call, then all the options would likely expire worthless, and you'd keep the total premium.

The potential result: Selling the call spread doesn't increase your overall dollar risk, but it could hurt you if the stock reverses course and moves higher as you anticipated. The potential reward is limited to any premium collected, minus transaction fees, and there's risk to the new position if the stock tanks or if shares rally. The downside risk is equal to the strike price of the put minus zero (because a stock can't fall below zero) minus the premium and the upside risk is equal to the long call's strike price minus the short call's strike price, minus the premium. Remember, attempting to adjust a trade is essentially putting on a new trade. Understand the new trade's structure and plan for a new outcome.

The situation: What if you sold an OTM call or put vertical and now it's turning into more of an ATM spread because the underlying stock has moved in the wrong direction and the spread is now showing a loss? There's often more than one way to adjust trades that go against you. So, here are two possible approaches for short vertical spreads when the underlying stock is getting too close to the strike price of the short option.

The adjustment: You could consider rolling into a new vertical spread. If the stock is threatening to trend right through your short vertical, closing the spread and opening another spread with different strike prices and a further expiration might be a possible adjustment, depending on the trader's forecast for the underlying stock.

For example, using an underlying stock price of $80, suppose an 82-84 call spread was sold for $0.30 with a few weeks to expiration, or, hypothetically, selling the 82-strike call for $0.90 and buying the 84-strike call for $0.60. Some time passes, but the stock has moved higher to $82, with a week until expiration. You could consider "rolling" the spread to a further expiration and higher strike prices by buying it to close for a debit of $0.40 (buying-to-close the 82-strike for $0.65 and selling-to-close the 84-strike for $0.25), and then selling to open the 84-86 call spread with 50 days until expiration for $0.60 ($1.35 credit minus the $0.75 debit). Using the prices in the table above, the roll plus the new vertical can be completed for a net credit of $0.20, not including transaction costs. The new risk is the difference between the two strike prices minus the credit, or $1.80 ($2 minus $0.20).

The potential result: Now your short strike is $2 further out of the money, giving you some breathing room. The trade, however, now has more time before it expires. So, you'll need to monitor things in case you need to make another decision to roll again or exit. Finally, remember additional adjustments mean additional transaction fees.

Every attempt to adjust a trade has its pros and cons. But you can potentially cut your losses by selling options premium elsewhere without necessarily exiting the trade. If you do, you can potentially stay in the trade a little longer and see if your initial forecast proves correct.