I know the basics about option structure, but applying particular option strategies together within an account, and taking into account overall market direction/hedging is another matter. So I'd like to use this thread to ask a few questions to help in structuring my understanding. Firstly, If you apply only Put and Call spreads within your portfolio - nothing fancy like flys, or god forbid, Condors, should you consider an equal portion of each, so your account can be hedged against any sudden overall market movements? EG If I decided to execute a strategy to trade ATM credit spreads, where my risk on each position is limited to the Long-Short spread, is it prudent to enter as many Call (bearish) credit spreads as Put (Bullish) credit spreads? If the market rallies or tanks, in theory, the winners on one side will cancel out the losers on the other. This is of course based on the idea that each position risk/reward is equal weighted. Cheers!
No. I'm talking about diversified credit spreads over different instruments. Equities mainly. I also tend to differentiate credit spreads from Condors not only in terms of structure, but the difference between ATM and Far OTM options for Condors. Not sure if that's technically correct, but its the way I've thought about it.
<<< EG If I decided to execute a strategy to trade ATM credit spreads, where my risk on each position is limited to the Long-Short spread, is it prudent to enter as many Call (bearish) credit spreads as Put (Bullish) credit spreads? If the market rallies or tanks, in theory, the winners on one side will cancel out the losers on the other. This is of course based on the idea that each position risk/reward is equal weighted. >>> In "theory".... yes. In reality.... no. My guess is most here will disagree with me, but if you are setting up your portfolio to be in "balance" that way, I think the end result may be the loss of about 50% of your account value.... minus you credits. Just keep in mind your credits on one side will NOT equal your losses on the other. And if you are doing individual bullish/bearish spreads on different stocks, vs doing an IC, then in theory, you could lose on both sides. It's one thing if you genuinely find a somewhat equal number of individual stocks you are bearish/bullish on for fundamental and technical reasons.... which also have somewhat similar credits and otm/atm safety cushions,...which is unlikely. It's another to try to put your account risk in so-called balance, via an equal number of bullish and bearish spreads. Credit spreads can be a lot more risky, and destructive to your account value than you may be aware of. Don't let the "theory" of what you are hoping to accomplish, mask the "reality" of the stress you may be setting yourself up for.
Thanks for your input PM. Are your responses based on IV should markets correct or rally? I can understand seeing quite a skewed Open PnL when volatility increases, however at the end of the day, ie expiry, those spreads that are OTM will expire worthless. I should also add that all trades are entered only on the condition that the profits at expiry exceed the maximum losses by at least 10% For example, take the URBN 36/37 Mar13 Call spread. Its priced at 0.70. If my analysis is correct, and it expires worthless, I make $70. If URBN sells above $37 @ expiry, I lose $100-$70 (initial credit) = $30 So the win is 2x the loss. I am only trading cash secured, so if I am put to stock AND the long side expires worthless, I must exit the next day with a MOO order. I concede that I needed to mention that my winners are always much more than my losers, which is important should the overall market move deep in one direction. Are there any other risks in 'reality'? I understand it won't be perfect: an Oil and Gas exploration stock will not be a great hedge against Footwear Apparel, but with 20-30 such positions, it might even out better than being all Long or Short
<<< So the win is 2x the loss. I am only trading cash secured, so if I am put to stock AND the long side expires worthless, I must exit the next day with a MOO order. >>> If you are trading credit spreads as a strategy for your portfolio, you will be on 8 - 10 times margin leverage of your accounts net worth. That being, if you have a $100,000 account used for spreads, you will be managing margin of close to a MILLION dollars for your account. I'm going out soon, after I post a trade, so I'll read you later.
condors to me are just a fly that doesn't have one center strike.. degrees out of the money mean nothing in regards to its name
How so? If you make a decision to trade only cash-secured, then why would your account end up in margin? So I have taken a closer look at my real yield if I trade only cash-secured, and I'm pretty convinced your statement is correct. I'll have to use margin to make any profits from credit spreads. Thank you for pointing it out to me. So if one is using margin, assignment risk is a real issue, when price settles inbetween the two strikes. How does anyone on margin mitigate that risk? Exit the position prior to assignment? Many years ago I traded calendar spreads and lost a bundle when I blundered on a margin position for a stock that went ex-dividend over the weekend, being assigned on my short leg. I'd be keen to avoid those types of issues going forward
Don't confuse not being charged margin interest with not being on potential margin leverage. If you are doing credit spreads you are automatically using leverage. For example, asssume you have a $50,000 in your account. Lets do credit spreads, using that entire $50,000. For the purpose of the example, lets make it simple and say you are putting it all on either one $50/45 spread or 10 of them. It makes no difference, as either way all your cash is used for 5 point gap spreads. Strike of $50. Suppose your stock drops below 50, and is trading midway between $45 and $50, and your 30 - 40 day contracts have 2 - 3 weeks left in it. Perhaps you like the stock and your very reasonable price for the stock. If it remains under $50 can you consider buying the stock if it gets put to you, or do you need to consider closing the trade for a partial loss? You can initiate 100 contracts with your $50,000. That means you need to come up with $500,000 if your contracts are put to you, so you can own the stock(s). That is 10 times your account value. So you can NOT buy 95% of your stock(s).... which are already under your strike. Thus you are left with 2 choices. Close the trade as soon as the stock trades inside your spread, to minimize your loss,... or wait and hope for a recovery back above your strike, before the contract expires. HOWEVER, if you risk waiting for a recovery, and the stock instead drops a mere penny below your $45 strike on exp day, your $50,000 account will be 100% wiped out.... minus any time value remaining and credits earned,.... (unless you used those credits to initiate even more spreads.) If you are going to sell credit spreads, i suggest closing them down BEFORE the stock gets inside your spread. Once it's inside, your rate of loss really picks up steam, if you decide to close them now. The deeper it gets, the greater your loss. And once it hits your lower strike, your money is all gone. Thus, since it's risky to let your stock get inside your spread, that means the otm safety cushion you think you have, is really just an illusion, as you dare not let the stock touch it, or get inside. And the more narrow your spread, the more risky the trade, once the stock is inside. Not much of a cushion between your 2 strikes with those 1 - 2 point spreads. And once the stock drops a mere penny below your 2nd strike, all your money is gone.... minus any credit and time value remaining. Not that big a deal for the occasional spread trade in your account. But if you put all your money into spreads, as you were talking about doing, you risk a 100% wipe out of your account, or close to it. A really bad week or two in the market could easily do it. Even less time if your trades don't have much of an otm cushion. Bottom line,.... when you initiate your "so-called" cash secured credit spreads, consider how much it would cost you to buy the stocks if it dropped inside your spread. If you can not afford to buy them, don't wait until the stock gets inside your spread before you close it. Because once it's inside, you are now closer than you want to be, to being wiped out. This is assuming you are using all your cash for spreads. Not that big a deal for the occasional spread on a stock you feel is more volatile than you are comfortable with. Spreads are actually a reasonable strategy to protect your cash when investing in volatile stocks or when earnings are pending inside your contract date. But very risky when you invest all or most of your account cash in them. What started as a cash secured strategy can suddenly put you on margin of 10 times your account value. Since you can NOT be on margin of more than about 3 times your account value, you will NOT actually be on margin. Instead, your broker will simply close the deteriorating trade for you on exp day, and let you suffer your losses. BTW, the higher the strikes you use, the more "potential" margin you will be on. And thus, the less control and fewer options (choices) you will have to "manage your risk", if/when things go bad.
PM, I really appreciate your explanation. I am not sure if I completely understand all of it, I'll need some time to digest it all. It sounds like your primary point is options expiring within the spread. What happens at expiry when price is outside the spread? Ie when both strikes are ITM? Will the broker (IB) still close the position on the day if my short (post assigned) position is larger than my margin capabilities? Or will they both be assigned over the weekend, and cancel one another out, realising the only the spread loss? Ie URBN 36/37 Call credit spread. Stock is selling at $38 on the Friday prior of expiry. My account is $50k and I have 100 spreads. The $36 short ITM will assign 10k shares: 360K value - far higher than my margin account. But I also have 100 37 Calls that are ITM. My thinking is that IB will not just take on that risk automatically. Will they close the position, or perhaps do they just lock the long call to prevent a client from closing the position and taking on excessive margin? You have stated that Brokers' modus operandi is to close the short position on the Friday prior to expiry when the stock price is within the spread. If this is so, then any time your short option is ITM, you have the risk of being assigned - too much uncertainty in my mind to engage in on an excessive margin basis, or have an account fully allocated to this strategy - as you stated. Also, you recommend closing the position when price gets within the spread. I have been seeing alot of info that talks about studies that show the greatest profitability can be found when trading ATM options. As soon as you start going OTM, Risk:Reward diminishes, and blowouts seem to be far too often. What would you suggest to someone who wants to (feels most comfortable) trading ATM options. Flys? Thanks again for your advice.