SPX Credit Spread Trader

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In April 2005 during the 3 day period of Apr 13-15, the SPX plunged from 1187.20 to a closing of 1142.62. This was a drop of 45 points, 3.8%. Does anyone recall the event(s) that triggered this sell-off?

 

If memory serves:

The drop on April 14 and 15 was mainly due to the bad earning report from IBM. The information was leaked to the public, so IBM announced their earning miss ahead of schedule. I cannot recall what happened on April 13, 2005. April 15 was expiration Friday. You may like to look at the chart of IBM for this period of time.

 

Yes, I too am eagerly looking forward to learning about this strategy. The black swan event is the one thing that makes me nervous about trading credit spreads even FOTM spreads. Most other events, I feel I can risk manage fairly well.

Look forward to this.

 

OK folks here is the Black Swan Insurance Plan my friend discussed with me and I want to share it with you.... cause that is the kind of Coach that I am Remember this is for large major nasty moves lower.

Now that the VIX has options trading, we can use them to insure our spreads against Black Swan events.

First, since VIX is newer, let's look at a chart of VXN going back to its beginning in 2001:



Notice the period around 9/11 where VXN spiked to to 90 and also notice where the VXN spiked to 70 during some other market drops in 2002. Assume that VIX existed as well and it would have had the same moves on a really nasty event or drop in the market.

Now let's look at the new VIX options which started trading in February I believe:



Now assume that I put on a MAY position with way OTM put strikes, about 80 - 90 points and I take in a credit of $12,000 with my usual positions. I then take about $3,000 and purchase 120 VIX MAY 20.00 Calls at $0.25 for $3,000. Net credit is about $8,000 at worst after all commissions (just using worst case), and you have a pocket insurance policy.

If something nasty occurs and the market drops (post Katrina VIX got close to 20 and this was not a Black Swan type of event), the VIX will skyrocket well above 20. Assume the market falls 50 points or so quickly on some nasty shit and the VIX jumps to 42. Your 20 strike calls will be worth at least $22.00 *120 *100 = $264,000.

That will pretty much cover most, if not all of your potential loss on the spreads which most likely will not even be ITM yet but quite expensive due to delta/gamma and IV. So it will not be at full value but pricey enough. With the VIX option insurance proceeds + your initial credit, you have enough to close out the position with a hair of loss at worst and you survive the Black Swan event.

You could buy these each month as you open put spreads or look out longer term and maybe in April or MAY spend some profits on longer-term calls and let them sit.

You could do bull call spreads to get a cheaper cost with fixed insurance payout. In other words if you can get the 17.50/20 bull call spread for $.15 then you can do 200 with a max payout of $2.50 per spread. I think it is better just to go long the calls.

THIS WILL NOT WORK IF MARKET BLEEDS LOWER TO YOUR SHORT STRIKES like in post Katrina. Although VIX jumped it did not explode even though the market moved like 50+ points. This insurance is only for the huge 9/11 or nasty market plunge that is sudden and nasty.

So there it is folks.... the Coach Phil (copied from his friend) Black Swan Insurance Plan

 

Coach - this is quite clever.

1) Have you tried modelling it in the TOS Analyze page?

2) What are the tradeoffs of buying VIX options with 30 days-to-exp versus, say, 180 days?

 

Coach,

did you ever check/consider 2-year T-notes futures or Eurodollar futures ?

 

The correlation between nasty crap events and VIX spikes is much simplier to visualize and trade then to get involved in the margin or complexities of futures or how the T-notes or Eurodollar moves when the market crashes (well for me at least).

This is a nice vanilla no-frills approach that anyone can do in an option account without the need for futures or understanding interest rates . If the two you mentioned work as well, then maybe this is just one more tool...

 

1) I have not modeled it because I really do not know where VIX will spike to on any downward movement but I do have some confidence that it will spike higher above 20. I have no guarantee that VIX will go up if the market crashes but it seems 99% probable (made up number ).

2) Trade off is simply cost. My friend buys it month to month with each spread sale so that it is a covered sunk cost and the net credit is still attractive. I discussed with him the idea of in December when all profits are built up, buying a long-term VIX insurance plan for the following year through the summer perhaps but again the cost upfront is pretty high. Since this strategy brings income month to month, it may be better to do it month to month except for those times you have a strong up-trending market and are well OTM were even a 50 point pullback will not hurt you.

One coudl simply buy this in January for the longest time possible and play the fat tail insurance event. There really is not one way to play this but month to month costs to coincide with month to month credits will help you absorb the cost easier perhaps.

 

Agreed, the only thing is liquidity. 400 contracts front month daily is not impressive, unless it gets better.