Credit spread - deep otm - false sense of security?

Discussion in 'Options' started by Put_Master, Aug 8, 2012.

  1. When initiating a credit spread, some traders may consider accepting a lower credit, for an even deeper otm safety cushion, and thus a subsequent higher "probability" for a successful outcome.
    In theory, this makes sense.
    But here is the potential problem with that theory:

    If you compensate for that lower credit with a higher number of contracts, and/or you use high priced strikes for your spreads, you now face a potential double delema.

    That being, you know you can not possibly buy most of those contracts, if the stock falls between your strikes.... particularly if your strikes are high priced. And you also know you risk a total loss of your cash, if the stock falls below both strikes.

    Therefore, because of the amount of cash required to buy all those contracts, and/or the amount of cash you risk losing if stock drops below both strikes, the stress of being in that "no win" situation, will make you afraid to let the stock drop anywhere near your upper strike.

    Therefore, that deep otm safety cushion you had when you initiated the trade, becomes more "theoretical" than reality based,... as your fear increases the closer your stock gets to your upper strike.
    Thus, you must consider closing down the trade, even while the stock is still somewhat otm, as the closer it gets to that upper strike, the more dire the consequences.
    So my question is, what good is a super deep otm safety cushion, if you fear letting it even come close to being tested?

    While this situation may not be as serious if only one stock is traded, it becomes increasingly more serious, as the number of spreads in your portfolio increases.
    Particularly if they are all dropping at the same time, during an overall market correction,... and you know you can not possibly buy all those contracts. And/or you fear a devastating wipe out of your account, if you let the stocks continue to drop below both strikes.

    So I again ask.... What good is a super deep credit spread otm safety cushion, if you fear letting it even come close to being tested?
    Hence a not so obvious risk of a portfolio composed of credit spreads,.... even if they are all initiated super deep otm, instead of taking a higher credit.
  2. hedgeman


    Standard credit spreads are one of the fastest ways to financial ruin when volatility spikes. If we have learned anything over the past few years, volatility tends to jump after a period of time of being on the floor and it does not take much to set the VIX or RVX screaming higher.

    This is where credit spread traders are caught, should they close their trade down for a loss or wait it out and hope. Hope should not be part of the strategy. This is a large reason for many traders losing big time and not coming back.

    The further out of the money you go, you take in smaller credit but you are risking more money. This is a neg vega trade. If you want credit, at least make the trades back ratios, this means having more longs than shorts to neutralize vega and start closing the trade down a couple weeks before expiration to avoid gamma risk. This is my favorite trade. If you want to be in this game for the long term, that is the best advice I can give.

    In TOS, I always open trades at least knowing what an increase in volitility and time will do to my trades. Many traders don't really focus on the losses that can occur but rather on that tiny credit and daily time decay. Such a dangerous way to trade because sooner or later, you will be caught when market psychology changes. Thats why you will lose, too. With back ratios, you will have more control of vega and don't be so concerned with theta, this will come into play as time passes. Vega is what you need to focus on, especially in these low volatility environments.
  3. <<< Standard credit spreads are one of the fastest ways to financial ruin when volatility spikes. If we have learned anything over the past few years, volatility tends to jump after a period of time of being on the floor and it does not take much to set the VIX or RVX screaming higher.

    I'm glad we agree on the risk of doing spreads, and that they are riskier than many traders realize.
    However, I "somewhat" disagree that a rise in VIX may significantly negatively affect the trade, as the long and short leg of the spread are both affected.

    The more narrow the spread, the less negative affect a spike in VIX will have on the trade.
    HOWEVER, the more narrow the spread, the less cushion you have for a stock to trade between your strikes,.... thus resulting in a greater risk of a total wipe out, when it drops below both strikes.
    But the wider the spread, the more negative the affect of a rise in VIX.
    So there is a downside to both situations.

    It's now 2 am here in Vegas, so I'll read you in the am.
    Thanks for an excellent discussion.
  4. hedgeman


    Ok, its 5:20PM here in the Philippines ha.

    When vol jumps, all options cost more money, in a standard credit spread, the trade loses since the short is closer to the money. Like I mentioned, if you are using TOS, set up a credit spread and then just adjust the volatility and price to see how the trade is affected.

    Yes, you make a good point, when the spread is narrow, volatility has less of an impact, the trade off would be less theta decay. But, as I mentioned before, time decay is not as important because if you take care of the vega risk and maintain a positive vomma on the trade, theta will come into play as time passes.

    I trade the RUT exclusively with back ratios and far out unbalanced put butterflys in a PM account. I say PM account not to impress but to show that I can trade size because I have control and confidence in these trades. These are in my opinion, the safest trades one can make in this business.
  5. A very good discussion from someone who is currently focused on those far OTM Credit Spreads... I have the experienced the pain of loss yet, although I have had some close calls.
    You are opening my eyes to more potential risk then I was considering. For that, I thank you....

    Have not been to Manila for a couple of months... visit several times a year.
  6. recipe for disaster.
  7. newwurldmn


    I tihnk that if you are selling options or spreads (selling vol without delta hedging), you should look at your risk in notional terms instead of margin or max loss terms. Options will move at the speed of the underlying which is means your portfolio will move at the speed of the underlying * notional / accountvalue.

    Returns look a lot less attractive (instead of making 40% on margin requirement, you are making 2% on notional) but you get a better sense of what your risks are.

    To OP's point, if you sell 5% OTM spread and do it 2x notional is that better than selling 10% OTM spread and doing it 4x notional to make the same return on the portfolio? You can quickly see the tradeoffs of moneyness and leverage to the portfolio.
  8. hedgeman


    I am glad to at least get you to think of potential risks in this type of trading. I don't want to discourage your trading but rather enhance it, make it safer and keep you in the game. Put those back ratios on paper and compare to standard credit spreads, you'll see how much safer you'll be trading and why. Trading is fun and not supposed to keep you up at night unless you are wanting a stroke or heart attack. Keep those positions safe. Stress test your trades before you put them on.

    I'm in Angeles City, city of angels.
  9. Opening eyes is what this discussion is all about.
    Before initiating any spreads, particularly if your portfolio is composed of them as an overall strategy, always first evaluate what it would cost to buy them all, if they traded between your strikes.
    If the cost is excessive, your only "option" left, is to close the trade during difficult times.
    And depending on where the stocks are trading at that difficult time, that loss may be massive,.... or perhaps even devastating to your account value.

    Don't let your mindset get lured into that "false sense of security", that spreads often lure investors into. That your losses are limited to the difference in strike gap.
    Because until you actually calculate the actual cost and risk of either buying all those contracts,... or the cost of actually closing those spreads when the stock is trading between your strikes,..... you have no idea of the potential risk you may be exposing yourself to.

    Investors tend to use spreads as a safer alternative to selling naked puts.
    In reality, spreads may expose you to considerably MORE risk than investors realize, or even thought possible.
    Regretably, too many will find that out the hard way.
    Hence the purpose of this thread.

    The purpose of this thread is not to discourage investors from using spreads as a strategy. But to make them aware of their true risks, so they can manage their accounts more safely, more strategically, and more intelligently.
    Because during difficult times, managing the potential risk profile of a $15 (5 point gap) spread and a $50 (5 point gap) spread, are NOT the same. They are NOT even similar.

  10. Thanks for your input.

    I only know to trade options - spreads, iron condors , covered calls. I donot know what to trade for comparatively low risk. In order I can survive I keep my cushion level at 70% in my portfolio margin a/c.

    Please tell us what can we do? I seriously want to find alternatives,
    #10     Aug 8, 2012