Trading would be simple if Implied Volatility (IV) stayed high and we could short option premium knowing that the actual move would always be within the range of the expected move. That’s a fantasy. The reality is that when we establish undefined risk trades such as Straddles and Strangles the directional movement may force us to make adjustments. We can roll the untested side towards the current price. We can roll out in time using an option with a later expiration. We can also go inverted. What exactly does it mean to go inverted? Why do we do it? What are the mechanics? How does it impact our P/L targets?
A graphic of rolling up the untested Put side of a Short Strangle closer to the underlying price was displayed. Should the underlying continue in one direction past its expected move, you may have to roll up the untested Put higher than your Call strike. An example of a short Strangle in XYZ stock that went inverted was displayed. The example showed the initial strikes, the roll up and the inversion. A graph of the P/L on the original trade, roll up and inverted trade was also shown.
Now that we have explained how we established this inverted position, how do we manage it? Our potential profit is equal to the total in credits we have received minus the width between the strikes. We look to manage this inverted spread at somewhere between 50% to 75% of potential profit. A table of an inverted trade managed at 66.7% of max potential profit was displayed. The table included the total credit, width of inversion, max profit, profit target and level at which to take the profit.
Tom noted, “this will show you why we keep the dream alive, because more times than not we reduce the loss by extending duration and by allowing the underlying to be cyclical.“
For more information on Getting Inverted see:
From Theory To Practice from June 13, 2016: "Inverted Adjustments"
Best Practices from July 6, 2016: "How To Get Inverted"
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