Trade Adjustment on Option Strategy

To visualize a Trade Adjustment on a Option Strategy. Let us consider the following scenario. Currently Nifty is trading 5248 and based on our market analysis we are bullish on Nifty. We have identified the Diagonal Spread as suited for our analysis. How do we make trade adjustments when the position moves in our favor or against our trade.

S.No	Strike Price	Type	Expiry	Price	Position
1	5200	CE	June - 2012	196	Long
2	5300	CE	May - 2012	87	Short

We initiate the above position based on the following advantages. 1) We are short current month ATM option as it has low delta and high theta.

2) We are long next month ITM option which has high delta and low theta.

These advantages applies when Nifty is in a range from 5190 to 5310. Outside this range we lose the delta positive and theta positive factor of this strategy.

Assume that our analysis was wrong and Nifty falls to 5150. When we entered our position we had a net debit of 109. At 5150 the debit falls to 95. At 5050 the debit falls to 70.  What it means is that at the first 100 point fall we had a loss of 14 points and at the next 100 point fall we had a loss of 25 points. If at 5150 we are still bullish on Nifty. Then our trade adjustment should be to move the strike price lower and close the previous position

S.No	Strike Price	Type	Expiry	Price	Position
1	5100	CE	June - 2012	----	Long
2	5200	CE	May - 2012	----	Short

Assume that our Bullish analysis of Nifty was correct and Nifty has moved 100 points up at 5350. The net debit is 125. If Nifty will move to 5450 then the net debit would be 130. This means that for the first 100 points there is a profit of 16 points and for the next 100 points there is a profit of 5 points. If we continue to be bullish on Nifty at 5350 then our trade adjustment would be to move to higher strikes and close the previous position

S.No	Strike Price	Type	Expiry	Price	Position
1	5300	CE	June - 2012	----	Long
2	5400	CE	May - 2012	----	Short

Trade Adjustments are strategy specific. Some trade adjustment would mean closing one leg of the trade. But this would again expose one to the same risk that one tried to avoid by entering a spread.