Hi, Question regarding managing vertical spreads. I’m fairly new, spent the last month selling naked puts on Blue Chip stocks. Initially I wasn’t comfortable having zero downside protection and wanted to hedge risk by selling Vertical spreads so i opened some up recently. I hear a lot of platforms advising to “close” trades if X % of profit can be realized. But today while looking at my positions i saw something that I wasn’t sure If i was missing something or not. I opened a bear call spread on Monday for a net credit of .23. Today I closed the short side of the trade for .02. The platform i use allows commission free trading with the buying to close of positions IF the price is less than .10. If i would have closed BOTH sides i would have paid a commission on the trade for closing the initial buy side. I spent less money closing the short side keeping the long open. Than if i would have closed both positions. Is it best practice to just close the short option in this scenario? Only started trading options this past month so pardon for the elementary questions.
The short side is the only side that carries risk when you close out a worthless option, so yes, you're doing it right. Plus if you happen to be holding the long side when whatever black swan hits, you can exercise it whatever. One thing though, when you're trading the last few days of weeklies, when they blow up on you, they do so badly. Taking 23% of the spread as credit to open likely isn't enough to cover the bad losses unless you're hedging.
Can you speak more to that? I’m not sure i understand fully. I believe you’re insinuating a $1 strike gap. .23 or 23% isn’t enough premium to cover when a position goes again me. What is a hedging strategy for this scenario?
No need to apologize for elementary questions. We all start somewhere. It makes no sense to carry the risk of a short option when there's a further profit potential of two cents more so closing it is the right thing to do. Doing so opens up the possibility of either running with the unencumbered long option or morphing it into another option combo position - but that's probably beyond your pay grade right now. Bear in mind that if your long leg has value, there is risk in it, meaning that you can lose that value.
Was I wrong? There's only so many spreads that can describe with price movement like that. If I could answer that well, I wouldn't have blown up a couple weeks back I've been using SPX / SPY / QQQ with bearish debit spreads against bullish positions.
Widen your strikes. Close the spread when the remaining unearned credit does not justify the risk. Example: spread is worth $.10 and there's 7 days to expiration. Some guys swear by closing when you earn 50% of the premium. To each his own, just always make sure the juice is worth the squeeze.
With vertical spreads, if it's a debit spread, that's the risk and the reward is the difference in strikes less the debit cost. For credit spreads it's the opposite. The reward is the credit received and the risk is the difference in strikes less the credit. In terms of the amount of premium to cover when a position goes against you, it's not that simple. Verticals that offer a lower credit are more OTM and there is more stock price buffer until the short strike is reached. Selling one for a larger credit means that there is less distance to the short strike and the position can go against you sooner. The long leg is the hedge in this strategy. You can alter the position if you want more protection but that cuts into your reward. Pick yer poison.
Ok, don't do this. That increases your absolute risk with a negligible bump to the statistical risk. This comes into play on the other side is the grand risk/reward equation. You take on almost no statistical risk in terms of credit received, but take on a large absolute risk when it moves against you. Especially when you're in weeklies that close to the money. Unless your playing so much capital that this risk is watered down in each week you're trading, it's an awesome strategy until it isn't, then it sucks royally. Remember (in this order, and courtesy of another ETer): 1. Don't go you jail. 2. Don't get fired. 3. Don't lose money 4. Make money Note number three above 4. Manage risk first, look to reward second. Don't be. I blew one week in a well managed strategy. The drawdown was mid 40s (I think...haven't actually engaged in that masochistic calculation yet to see how bad it really was). But I was prepared for that type of move, so it was a bump in the road, not a car wreck. I've made that back and then some in the two weeks sense. Also, listen to @spindr0, he knows his stuff!
I guess I should have qualified the "widen strikes" comment. Everything I've read shows a statistical advantage regarding profitability when earning sufficient premium relative to risk. If the strikes aren't wide enough, you'll never earn enough premium to cover the losses. Obviously you can't go too wide; I've found there's a bit of a sweet spot. Account size matters as you'll be able to go wider and/or trade the SPX vs. the SPY if your large enough to stay within 1-2% account risk. There must be a firm mental stop loss/adjustment point though. You can't simply set it and forget it. Feel free to challenge my thinking. My feelings won't be hurt.