If tomorrow I were to sell Mar 08 '80put' options for 3 pts, If a crash came along, I could possibly have to buy it back for 10x, 20x, 50x, etc. of what I paid for it. (This is possible correct?) What happens in the above scenario if I would purchased a 75put for mar at 2pt creating a credit spread? How much would a 75 put protect me from the astronomical advance in premium that would surely come on a huge downmove? Is it only naked put writing thats extremely risky. Does a lower strike hedge curb this to at least a 'managable' degree?
I would be interesting in seeing the math that convinced you losing "50x" on such a position was a possibility.
I recently read an article where the author stated his oex puts that he sold for $100 went to $8000 on the day of the 87 crash.
In a crash everyone wants puts, and the lower the strike, the more sought-after they are. So yes, if 80 puts have an astronomical rise in premium, 75 puts should have as much of a rise or more. If you want to be precise though, keep in mind that if the underlying remains above 80, the 80 puts will have more vega than the 75s. In any case, in your scenario your loss is limited to 4 points per spread no matter what happens (5 points loss on the spread minus the 1-point credit you received).
If the skew becomes parabolic, then the 75 put IV rises more than the 80 put IV, which is exactly what I said.
I think you mean "of what I sold it for" at the end of that sentence. Remember you are SELLING a put and then BUYING it back. If you sell an 80 put and the stock or index goes to 0, you could be forced to pay about $8000 to buy it back. In that case, it would be around 27 times what you sold it for. Yes, the put spread limits the risk. At expiration, the most the position could be worth against you is $500, making your risk $400 since you got $100 for it. The 80 strike should never cost more then about $500 more then you can sell the 75 for. For example, if the stock/index fell to 50, the 80 would be about $3000 against you, and the 75 put you owned would be worth $2500 for you. JJacksET4
Every so often, I run a stress test at IB for my trading portfolio. It calculates what happens to the portfolio in extreme situations as well as more likely scenarios. It calculates what happens if the underlying or the stock moves -30%, -20%, -10%, +3%, +10%, +20% and +30%. Unfortunately, the stress test cannot be run under theoretical positions. Anyway, you've got to keep a stop loss in mind, if you protective leg is deep OTM compared to your short leg (in the case of bull put spreads and bear call spreads. In your scenario where the spread is only 5 points, your stop loss is already built in. Personally, I think Mar options are too far out at this time. I would be entering FEB options instead.
No offense but if you don't know the answers to such basic questions you shouldn't be trading options unless your goal is to lose money quickly. I strongly suggest you find software or a website that lets you model positions. Then get a feel for how time, changes in volatility, etc. affect them. The CBOE learning center has lots of free info on the basics: http://www.cboe.com/LearnCenter/default.aspx To include a free program that's not very sophisticated but will get you started: http://www.cboe.com/LearnCenter/Software.aspx
There are two other things to keep in mind. One--realize that even though your amount at risk is smaller in the spread than the naked put, the tacit assumption here is that you do not use the rest of the margin you would have had to set aside for the NP in order to place other spread positions. In other words, just because you risk less on a position does not mean you will lose less if you put on more positions than you would have with the NP position. The bottom line here is still that you can lose the entire amount of the spread. Don't forget that fact just because $500 sounds like much less than whatever you can lose on the NP. Two--with a spread on a stock, etf, or American style index, it's possible for the underlying to be put to you prior to expiration. Then you would need to exercise or sell the long position to offset the assignment. So keep your eye on these spreads--you can't take a day off. Otherwise you could end up in a situation where the U/L has been put to you but you have not done anything about your long position. This could chew up a lot of the dollars in your account.