Let’s assume you’ve reached the adjustment point and now you’re looking at HOW to adjust. The goal of initial adjustment is to cut NET delta in 1/2, but more importantly it is also to remove or to reduce the rate of losses on the upside. That means we want to smooth out P/L curve on the upside. My goto adjustment is to buy OTM options or buy back a short call as it will reduce short gamma (the down pointing slope). Here’s an example:
A is P/L curve without adjustments. As SPX rallies that slope become more and more steep and losses will add up quick. B is P/L curve if I was to buy back 1 of short calls and reduce NET delta from -22 to -10. As you can see, the higher SPX goes the ‘less’ painful that move will be and it’ll give me time to roll up the bad side. So that’s the idea, cut NET delta in 1/2 and remove some of potential upside pain until bad side is rolled up. Selling more put spreads will not smooth out P/L curve on the upside and will add risk (more margin) on the downside, we don’t want to do that. Now your next question will be, so is it OTM calls or short call that I should be buying back. And the answer is either. If you’re thinking that SPX will move ‘fast’ then buying OTM calls will do the trick, if you think we’ll grind higher than buying back short call works. There are many ways to make this adjustment, I like the simplest – buy something to cut NET delta and lift the curve.