Quote from JohnGreen:
maninjapan,
Below is an example of locking in a profit, while still looking for more.
I will be using a simple vertical spread because it is simpler, but the BWB adjustment is relatively similar and you will get the idea of how it is done from the example, I think.
You start off with buying a vertical spread in the direction you think the stock is going (let's say down for purposes of our discussion). We'll set this up in GOOG (and I'm not making a recommendation to do this or not!) for purposes of our discussion.
initial position: +2 480 put NOV
- 2 460 put NOV
This position is currently slightly out of the money, and will grow in value if GOOG drops in value by very much.
Now, let's assume that GOOG drops from 485 to 460. At this point, the position will have grown a lot in value, probably from about $8 to $13 or so, depending on the time. The question is how to lock in the value without losing out on at least some of the potential gains.
Here are a couple of possible actions that would be quite suitable as adjustments.
1) You could roll the puts down, selling the current spread for a profit, and buying the 460/440 spread. If you sell the two spreads you currently own, and just buy one new spread, you cannot "lose" on the GOOG position (considered overall) because the profit is being used to purchase the new spread, and you can still make further gains.
2) You could also buy the 460/480 call spread (in the same amounts as the original put spreads) which would now be worth much less than it was at the original time of purchase because of time decay, and the drop in value of the underlying stock. Then, no matter what, the combination of put and call spreads will be worth very close to $20 at expiry. Interestingly, the nature of options means that if the put spread is worth $13, the new call spread should cost about $7. So you will have spent $15 (8 at the beginning, and 7 now) and be guaranteed about $20 at expiry.
At this point, you can actually play the market either way. If the market rebounds upward 25 points, you could then sell the calls for a significant gain (although I'd probably want to sell only if they were now worth $20 or more each) and still hold the puts hoping for a reverse downward again. If not, you are still guaranteed a profit.
One important caveat and an example related to it: in general, adjustments are BEST made when booking PROFITS! Locking in losses often means than you are really just digging a hole that you will need to get out of eventually. As many other wise students of options have stated, the best adjustment in many cases may simply be taking a loss, or at least reducing your position, rather than exposing yourself to much more risk in the faint hope of avoiding the loss.
To see this really clearly, imagine that instead of falling 25 points, GOOG had risen from 485 to 510. In that case your put spread has now declined in value from about $8 to something like $3. There is no easy adjustment with a good probability of success that will help you much. You will have lost time value that cannot be recovered, and writing other puts for NOV will work poorly (taking on significant risk) because they will all have declined in value compared to your original position. Buying calls will not be much help either because they will now be relatively costly compared to the original purchase point.
