What Is “Adaptive Options Trading?”

10/03/2011 10:00 am EST


This real market example shows how to plan and execute an “adaptive” options trade, which is actively managed in order to dampen the impact of large market fluctuations.

A futures trader is subject to two variables: market direction and market timing. He risks losing money if his directional forecast is wrong and/or if his timing is off.

An options trader, on the other hand, can isolate his risk of loss to one variable: large-magnitude moves in the underlying futures contract. And he can soften the impact of large moves by adopting adjustment techniques to deal with them. That’s one reason I prefer trading options rather than futures. I’ve found that peace of mind is directly proportional to my ability to reduce the number of variables that affect my positions.

How, some traders ask, is it possible to trade without market direction and without the level or fluctuation in implied volatility impacting one’s options positions? The answer is to construct positions that are "Delta-neutral" as well as "Gamma- and Vega-neutral."

See related: Delta-Neutral Options Explained

The technique for constructing, adjusting, and closing such positions is what I call "adaptive options trading" (AOT). Whereas most traders are speculators, traders who employ adaptive trading techniques are not speculating solely on market direction or on expansion or contraction of implied volatility. They are instead establishing positions that earn profits from positive time decay. In effect, "adaptive” option traders get paid through positive time decay to put their capital into the market.

They hold positions all the time regardless of how expensive or cheap option premiums are. They need to adjust only when their positions favor a move in a particular direction (when their Deltas become too positive or too negative), when their positions become sensitive to implied volatility (when their Vega factor diverges significantly from zero), or when their positions don’t earn sufficient time decay (when their Theta is too low).

See related: Option Traders: Don’t Trust Theta

An interesting aspect to AOT is that no forecasting is involved. Positions simply evolve over time. You change them by making adjustments in response to market moves. If you have a bias as to which way the market might be headed, you can create an AOT position that has a bullish or bearish orientation. If you feel that the market is going to stay in a sideways range, you can create an outright neutral AOT position.

Once you establish an AOT position, you go on automatic pilot. You monitor the graphic analysis of your position, which shows performance curves for different time intervals, and you monitor your Greek variables of Delta, Gamma, Theta, and Vega and let them tell you when it’s time to make a modification to your positions.

See related: Know Your Option “Greeks”

I could go on and on, however, I encourage traders to think about this particular way of trading.

NEXT: See a Real Adaptive Option Trade Example


Here’s an example of an AOT position using soybean options back in January:

Click to Enlarge

And here is the profit/loss graph for that trade:

Click to Enlarge

Entry cost is the recommended option premium paid (debit) to enter a trade. If premium is collected (credit), it will be designated in brackets (  ). Cost is not necessarily the margin required to hold the trade. The margin includes $50/RT per option.

Projected results are estimates. Actual profits may be less and actual losses maybe more. Past results are not necessarily indicative of future results. Trades are based on the previous day’s settlement prices. Futures markets move quickly, so evaluate the market before entry.

By Paul Forchione

Paul Forchione is an options strategist and can be found at TheAceProgram.com and TradingOptionsVisually.com.

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