SPX Credit Spread Trader

El OchoCinco · Jan 17, 2006

I have not looked into it but I doubt it is a safe course to assume the market makers are idiots and mispriced the option. Yes you collect a hefty premium but your margin requirement is through the roof and rewards could be staggering only if the index is at 1500 at expiration. Otherwise it is no different than buying the deep ITM call or saving all that margin and buying an ATM call spread with wide strikes.

I do not see any advantage to doing such a deep ITM naked put. As expiration approaches, the put price will approach parity or its intrinsic value and lead to loss or offset initial gains. Basically it is a strongly bullish play and you make more money with less risk choosing different strategies.

Quote from osho67:

Thanks optioncoach for your reply.

Now the question is " Is there some way to make money out of this. These prices at 1500 must have some usefulness ,otherwise why have them in an optrion chain?

Suppose I sell a naked put at 1500 and collected a hefty premium. SPX is European style so I have no fear of being exercised and with good money management the rewards could be staggering. If it goes against me I can take small loss and close. If it is going in my favour I can take advantage of erosion of time value and close out at a big profit.

Please comment. Thanks
More...

osho67 · Jan 17, 2006

Thanks Optioncoach.
I had not thought of the margin requirement.
I am still wondering what is the use of these prices? Are there any strategies that make use of these prices at 1500?
Sorry I am posting very ignorant questions.

El OchoCinco · Jan 17, 2006

I do not know why those strikes are open, someone may have requested them for whatever reason. I think whatever the actual answer is will not be fulfilling. I got enough problems worrying about the strikes that make sense lol...

momoneythansens · Jan 17, 2006

Thanks for the explanation Phil,

Have to give credit to GATrader for pointing this out back in October on this thread:

http://www.elitetrader.com/vb/showthread.php?s=&postid=862201#post862201

...though, you didn't seem as convinced at the time! Perhaps the explanation was not as thorough or clear.

Also, similar albeit homegrown strategy outlined by myself, again poorly, on this thread here:

http://www.elitetrader.com/vb/showthread.php?s=&postid=889072#post889072

If you're brave you can try legging into the bear spread (in your example) and reduce cost even further, in a similar fashion to what you do on the SPY. It can also be considered as another way of achieving "convergence gains" (the meaning should be much clearer now if it wasn't before) as riskarb puts it i.e. where your max profit is acheived at the short strike of your original credit spread. Again, there are many ways of playing this slingshot including buying ATM options from the "get go" in the assumption that you will eliminate their cost entirely or partially when the underlying moves towards your credit spread. Although the approaches are similar, I believe the philosophies are different, one being to fund an adjustment and the other to enhance possible max profits and reduce risk. Anyway, whatever makes money.

Whilst on the subject of Cottle, one of his catch phrases is "If in doubt, do half" i.e. close or adjust half your position of you aren't sure what is going to happen. Some folk seem to get stuck in the "all or nothing" mindset and it's useful to remind oneself that this is not necessary.

MoMoney.

Quote from optioncoach:

IV is not your main or significant risk when trading credit spreads which are 1 or 2 strikes apart. Since you have a spread you are short and long the option so the negative effects of IV on your short strike or significantly offset by the positive effects of IV on your long option.

The real risk is your delta/gamma and that is where your main focus should be when watching these positions and looking to partially hedge.

I had a great conversation with Charles Cottle over the weekend, many of you may know him from his books. He demonstrated a way to roll the position into a pregnant butterfly and turn the position from a significant risk one to a limited debit risk position.

Here is the hypothetical. You sell 100 of the 1190/1200 credit spreads for X with the market at 1280. Let's assume after some time passes that the market has broken through support and is at 1255 and you expect the bloodshed to continue. Also your credit spread has gamma-ed up like the Hulk and you want to repair/adjust.

You could roll into a pregnant butterfly by, for example, purchasing 25 of the 1240/1200 bear put spreads for Y.

If you map it out, you will see this is a pregnant butterfly with total risk limited to the new debit of Y - X. Y-X will most likely be lower than the cost to close your credit spread or even adjust it without any partial hedges. YOu now have a limited risk position with a huge kicker- a new maximum profit level at the peak of the butterfly at 1200.

For example, if the market is at 1200 at expiration/SET, your credit spread expires worthless and your 25 1240/1200 bear put spreads are worth $100,000! If the index settles at 1230, your pergo FLY is worth $25,000 - net debit.

So now you have dynamically converted your credit spread with a risk of $100,000 to a prego FLY with a limited risk debit and a profit potential that is tremendous.

If the market is at 1190 at expiration, the Prego Fly max risk is simply the net debit.

The way I would play this is to roll the credit spread into a Prego Fly and then sell another credit spread at lower strikes to finance the net debit and create a legged into very limited risk position with huge profit potential.

My mind was all on fire this weekend mapping these out and I tell you, this leads to an amazing way to hedge your credit spread and greatly reduce your risk and create potential for huge profits if the index falls into the Prego Fly profit zone.

Thought I would share with you...
More...

Chipper7 · Jan 17, 2006

Quote from osho67:

Thanks optioncoach for your reply.

Now the question is " Is there some way to make money out of this. These prices at 1500 must have some usefulness ,otherwise why have them in an optrion chain?

Suppose I sell a naked put at 1500 and collected a hefty premium. SPX is European style so I have no fear of being exercised and with good money management the rewards could be staggering. If it goes against me I can take small loss and close. If it is going in my favour I can take advantage of erosion of time value and close out at a big profit.

Please comment. Thanks
More...

I don't see how selling the 1500 gets you a hefty premium. You are selling at a discount. You are selling below intrinsic value (there is negative time value in these options) so that the index has to go up the amount of this time value before you break even.

Perhaps your "good money management" can overcome this, but I don't think that this is an easy way to make money. Perhaps, I am missing something.

Chip

labib52 · Jan 17, 2006

Quote from optioncoach:

IV is not your main or significant risk when trading credit spreads which are 1 or 2 strikes apart. Since you have a spread you are short and long the option so the negative effects of IV on your short strike or significantly offset by the positive effects of IV on your long option.

The real risk is your delta/gamma and that is where your main focus should be when watching these positions and looking to partially hedge.

I had a great conversation with Charles Cottle over the weekend, many of you may know him from his books. He demonstrated a way to roll the position into a pregnant butterfly and turn the position from a significant risk one to a limited debit risk position.

Here is the hypothetical. You sell 100 of the 1190/1200 credit spreads for X with the market at 1280. Let's assume after some time passes that the market has broken through support and is at 1255 and you expect the bloodshed to continue. Also your credit spread has gamma-ed up like the Hulk and you want to repair/adjust.

You could roll into a pregnant butterfly by, for example, purchasing 25 of the 1240/1200 bear put spreads for Y.

If you map it out, you will see this is a pregnant butterfly with total risk limited to the new debit of Y - X. Y-X will most likely be lower than the cost to close your credit spread or even adjust it without any partial hedges. YOu now have a limited risk position with a huge kicker- a new maximum profit level at the peak of the butterfly at 1200.

For example, if the market is at 1200 at expiration/SET, your credit spread expires worthless and your 25 1240/1200 bear put spreads are worth $100,000! If the index settles at 1230, your pergo FLY is worth $25,000 - net debit.

So now you have dynamically converted your credit spread with a risk of $100,000 to a prego FLY with a limited risk debit and a profit potential that is tremendous.

If the market is at 1190 at expiration, the Prego Fly max risk is simply the net debit.

The way I would play this is to roll the credit spread into a Prego Fly and then sell another credit spread at lower strikes to finance the net debit and create a legged into very limited risk position with huge profit potential.

My mind was all on fire this weekend mapping these out and I tell you, this leads to an amazing way to hedge your credit spread and greatly reduce your risk and create potential for huge profits if the index falls into the Prego Fly profit zone.

Thought I would share with you...
More...

Doesn' this become directional play? You risk $25000 to protect the $4000, or 5000 you collected from the 100 contract. You profit from this debit spread only if SPX settle below 1230 .Any settlement over 1240 you lose the whole $25,000.
At least that's is my understanding of this hedge.
Labib Imtanes

El OchoCinco · Jan 17, 2006

Mo:

re-reading GATrader replies it was lost on me but reading further he was quoting Cottle so I guess I just needed to hear it from the horse's mouth- Cottle himself LOL. So apologies to GATrader and you if I missed it.

In fact Cottle explained it to me by laying it out on his laptop with strikes and demonstrating the breakdown so it made it a lot clearer. Cottle is quite interesting and I truly enjoyed chatting with him at length (we were both invited to a Chartbender.com symposiun on option trading-

http://www.chartbender.com/cboss.aspx )

Great news on Cottle, he is taking all the info from Coulda Woulda and Shoulda and re-publishing it in a new book with even more info. It is coming out end of this month. If enough of you are interested I could maybe get a discount for a group or if you mention me as a referral (nothing back for me, just to get you a better price than the proposed $79.99 price of 430 pages) hardcover and in COLOR.)

Anyway, one of the reasons I am looking forward to risk based haircuts, is that rolling into the Prego Fly will reduce my haircut to the net debit and then I can sell further OTM credit spreads to finance that and have a FLY at no cost (still risk since I added another credit spread). However as an adjustment it allows for huge returns if the index enters the Prego Fly' belly and I can adjust the new credit spread the same way and keep taking my risk off the table and reducing it.

Quote from momoneythansens:

Thanks for the explanation Phil,

Have to give credit to GATrader for pointing this out back in October on this thread:

http://www.elitetrader.com/vb/showthread.php?s=&postid=862201#post862201

...though, you didn't seem as convinced at the time! Perhaps the explanation was not as thorough or clear.

Also, similar albeit homegrown strategy outlined by myself, again poorly, on this thread here:

http://www.elitetrader.com/vb/showthread.php?s=&postid=889072#post889072

If you're brave you can try legging into the bear spread (in your example) and reduce cost even further, in a similar fashion to what you do on the SPY. It can also be considered as another way of achieving "convergence gains" (the meaning should be much clearer now if it wasn't before) as riskarb puts it i.e. where your max profit is acheived at the short strike of your original credit spread. Again, there are many ways of playing this slingshot including buying ATM options from the "get go" in the assumption that you will elimate their cost entirely when the underlying moves towards your credit spread. Although the approaches are similar, I believe the philosophies are different, one being to fund an adjustment and the other to enhance possible max profits and reduce risk. Anyway, whatever makes money.

Whilst on the subject of Cottle, one of his catch phrases is "If in doubt, do half" i.e. close or adjust half your position of you aren't sure what is going to happen. Some folk seem to get stuck in the "all or nothing" mindset and it's useful to remind oneself that this is not necessary.

MoMoney.
More...

El OchoCinco · Jan 17, 2006

Not exaclty. The adjustment is put on because the market is moving towards you credit spread and you expect it to keep moving. Assume your credit is $5,000. If the market is falling you might spend more than that rolling down the spread or buying it back.

Adding the bear put spread for a Prego Fly will turn your net credit into a net debit position. You are not risking $25,000 at all, you risk now is the net debit as opposed to the $100,000 you had before. ANy settlement over 1240 you lose the net debit but it is a very small limited risk as opposed to the potential $100,000 risk you faced when deciding to put on the position. Pricing options now, I can turn my 1190/1205 put spread into a $7,000 debit spread Prego Fly.

If I saw the market falling hard I could take $100,000 of risk minus premium received and turn it into $7,000 of risk with a potential for huge profits should the market keep falling. If the market reverses and moved higher than the limited loss is a part of the limited risk hedge I slapped on when I was fearful of a large continued move lower. (like adding a ton of partial hedges and watching the market reverse which is the norm lol).

But the new wronkle is that after converting to Prego Fly, I sell another deep OTM credit spread to finance it and now I have a no cost trade with huge profit potential but still risk with the new credit spread, but now deeper OTM.

This is not a month to month adjustment. This is when I fear the shit is hitting the fan and my strikes are not safe. Instead of adjusting the strikes, I can roll into the Prego Fly. THis might be needed once ro twice a year but I will take the small limited loss potential of the net debit one or twice a year as a risk v. the full $100,000 risk of the example spread. Plus I get the bonus that if the market slides into the belly of the Prego FLY, I coud have significant profits.

So therefore I think your inintial understanding of the numbers was off. If you want a real life example, assume you got 100 1190/1200 for $0.45 and want to add 25 of the 1240/1200 bear put spreads to roll into the FLY. When I last priced it I believe it would be a net debit of $7,000. So you go from risking $95,500 to make $4,500 to risking $7,000 to make $93,000.

The point is that you just do not put it on at anytime. It is when you think the pending market moves could potentially put your spread in danger. So it is a "Break Glass in Case of Emergency" approach.

Quote from labib52:

Doesn' this become directional play? You risk $25000 to protect the $4000, or 5000 you collected from the 100 contract. You profit from this debit spread only if SPX settle below 1230 .Any settlement over 1240 you lose the whole $25,000.
At least that's is my understanding of this hedge.
Labib Imtanes
More...

ryank · Jan 17, 2006

Quote from optioncoach:

So therefore I think your inintial understanding of the numbers was off. If you want a real life example, assume you got 100 1190/1200 for $0.45 and want to add 25 of the 1240/1200 bear put spreads to roll into the FLY. When I last priced it I believe it would be a net debit of $7,000. So you go from risking $95,500 to make $4,500 to risking $7,000 to make $93,000.

The point is that you just do not put it on at anytime. It is when you think the pending market moves could potentially put your spread in danger. So it is a "Break Glass in Case of Emergency" approach.
More...

And to add to that Coach, you also said you would look at putting on a deep OTM put credit spread to help finance the debit position you just created. Not sure if you could get all of the $7,000 or not, depends on many things.

ryan

Heatheranderson · Jan 17, 2006

Optioncoach
Thanks for sharing this strategy with us.I have a question, though.At what point would you put on this debit spread.I mean, if we take your example.when the market enters 1240 or before that?.

------------------------------------------------------------------------------------
If you want a real life example, assume you got 100 1190/1200 for $0.45 and want to add 25 of the 1240/1200 bear put spreads to roll into the FLY. When I last priced it I believe it would be a net debit of $7,000. So you go from risking $95,500 to make $4,500 to risking $7,000 to make $93,000.

The point is that you just do not put it on at anytime. It is when you think the pending market moves could potentially put your spread in danger. So it is a "Break Glass in Case of Emergency" approach.
------------------------------------------------------------------------------------