The one thing, out of many, that sets options apart from stock is the ability and need to adjust positions. To adjust a stock position you simply close it out and you are done. Options carry with them a lot more risk such as, volatility risk, delta risk, gamma risk, etc. At some point during the life of the option you may need to adjust to reduce a certain risk.
Last week we set up an Amazon.com earnings options play. We noticed that volatility was lower than its previous earnings announcements. The idea was to buy the at-the-money straddle in anticipation of rising volatility into earnings.
In the short time the trade has been on it has been working nicely. Not only did we get a rise in volatility but we are starting to see a drop in Amazon.com (NASDAQ:AMZN). In fact, Amazon.com has dropped 6% and broken through the 50 day moving average.
With the drop we saw a rise in volatility going from 29.82 to 36.24 giving us a nice profit on the trade.
So where does that leave us?
Volatility is still not as high as we are used to seeing going into earnings, so the edge on the trade is still there. We want to keep this trade on. However, with the recent sell off we are starting to get real short in our deltas. With Amazon.com selling off 6% we should expect a bounce out of it. Any bounce here will hurt our profit because of the short deltas.
Let's go ahead and flatten the deltas out and reduce directional risk. The best way to do this is to close out half the puts. We are going to lock in the profits on half the trade and move the deltas back to neutral. Now if we get a bounce in Amazon.com we will increase our profit potential. Again we are trying to keep this a delta neutral strategy because we are after the increase in volatility not direction. We reduce the delta risk to focus on volatility.
Here is the original play:
Here is our adjustment:
And the new profit/loss graph with the adjustment: