If you are writing credit spreads or iron condors or what ever other method- how do you protect yourself from Black swan event? or you just cant protect and allow the a/c to lose substantial amount? In this fear I normally maintain 70% available funds at any time but I am not sure even this will help. Any ideas what can be done? Feedback much appreciated. Thanks
Cheap OTM calls and puts are considered the easiest insurance against "the big one". Keep in mind that the IV on far OTM options is generally higher than ATM every since Black Monday 1987. Look up "iv smile". Higher IV = relatively more expensive. You're paying a higher than average premium for this insurance.
I think the answer depends on how you define credit spreads, Black Swan and protection. The first one is easy. If you're writing bearish credit spreads, you're golden. The latter two aren't as easy. If you deem a Black Swan as a one day even with no warning, say 9/11, then you must have your protection in place. No ifs ands and lots of puts. Same holds true for the crash of '87 if you view it as a one day event. If you view the crash of '87 in terms of a two month down market and then a one day crash, there was plenty of warning and time to act prudently. The same holds true for last year's market debacle which started in the 4th quarter of '07 (even earlier in some sectors). With warning, you have several choices. Day to day losses can be cut by closing positions. Add'l cheap protective OTM legs can be added. Profitable legs can be rolled in order to generate more premium on the other side. Keep in mind that it's generally a losing battle to attempt to defend a position that's directionally wrong. You can mitigate a lot of the damage and soften the blow but it eventually takes a good rebound to get back to even if you haven't thrown in the towel... But at least a losing battle is a lot better than sitting there like a deer in the headlights allowing your a/c to lose a substantial amount. That's a big no no.
stevegee58 spindr0 Thanks for the replies. Why not just write spreads on the call side? Premium will be less but there is not much risk as markets cant go up in a flash. I tried to google iv smile but the explanation was not very clear. If you donot mind , plese elaborate more. Thanks
of course i agree with spin. my only 2 cents is if you have simple credit spreads and the market blows through them; there is no defense. short futures after the fact and you can get killed even worse. best thing is to close for the loss. you can move to fly's, debit spreads and other ratio type trades. even consider doing 2:1 RR trades. 5 point es spreads for instance. you can look all day long and never fully protect credit spreads.
Lower premium for call spreads would be true at lower IV. At higher IV levels, put spreads offer better premiums. How about writing bearish call spreads in a bear market and writing bullish put spread in a bull market? Or perhaps writing both? And then there's the possibility of practicing good money management to give you a better chance of surviving your mistakes.
Some people did this in the legendary journal, SPX Credit Spread Trader. Indeed, premium is less and much closer to the money than you would want to be in a bull market (or bear market rally for that matter). Even getting .50 cent credit. It's probably best to write bear call verticals on those 1-2% strong up days so you can capture premium farther out in the upside momentum, and you still want to buy some insurance. Note: i've never done any of this, just observation.
CBOE put out an article either early this year or later last year about the viability of using OTM puts (or selling OTM calls) as catastrophic event insurance. They tried to market this strategy like it was a layman's CDS. Pretty interesting stuff, makes absolute sense. I'm sure you can search the article at the CBOE website.
What I suggest is re-investing a portion of my credit by buying strangles. Sure it feels costly, but when you own net long options, there is no move that's too large to handle. I discuss this in The Rookie's Guide and on the blog. Here's a couple of posts: Mark http://blog.mdwoptions.com/options_...ecting-iron-condors-with-extra-strangles.html http://blog.mdwoptions.com/options_for_rookies/2008/09/q-a-buying-extra-puts-as-insurance.html