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Exploring Adjustment and Exit Strategies for High-Probability Credit Spreads and Iron Condors: Part 1

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Anyone who has ever been in a credit spread that's gone bad knows how painful a forced exit can be. A high-probability credit spread that brought in $0.60 per contract may cost one $2.00-4.00 to exit once the sold strike is closely approached. It will often cost much more than that to exit after a sold strike is violated.

There has to be a better way, right? Maybe. Maybe not.

This article and next week's explore some methods that I've tried or else seen suggested. The articles will not discuss the methods in depth, as that would require more space than I have available. Already existing webinars do explain them in much more detail.

Rather, these two articles are intended to introduce ideas to be explored as you follow me in my journey to better manage risk through managing delta, vega and theta risks. All traders should discuss the ideas in this article and the next with their investment professionals before embracing them. It's important to factor in a trader's risk appetite, available time for monitoring a trade, and psychological makeup before choosing an exit or adjustment strategy. Each has its pros and cons.

Those new to trading may need a brief review. A credit spread usually involves the sell of an out-of-the-money (OTM) option and the purchase of a hedging further OTM option of the same type and expiration period. An ITM credit spread is possible, of course, but most spread traders are trading these OTM versions.

For example, as this article was originally roughed out on December 5, my account included, among other positions, 20 contracts of an original 25-contract position of an SPX JAN 510/500 put spread. This was a bull put spread, in which I had sold the January 510 puts and bought the 500 puts to hedge the position. As of December 5, I also held a SPX JAN 1110/1120 position, in which I sold JAN 1110 calls and hedged by buying 1120 calls. This is a bear call spread. In each of these spreads, the option that was sold was closer in than the one being bought, and, so, more expensive. Since I was selling the more expensive option and buying the cheaper one to hedge, I took in a credit. The two spreads together make up an iron condor. Originally, I had 25 contracts of both credit spreads, making up 25 contracts of an iron condor, but I had bought back 5 contracts of the JAN 510/500 bull put credit spreads by December 5, when this article was first roughed out.

The trader who sets up a credit spread, even a high-probability one, may or may not be able to keep that credit at expiration. For example, imagine that the SPX were to settle in January at 505. Further, imagine that I hadn't done anything to adjust the position after December 5, when this article was originally roughed out. The JAN 510 puts I had sold would be worth $5.00 and the JAN 500 puts I'd bought as a hedge would be worthless. On that credit spread, I would lose $5.00 - 0.60 per contract, with $0.60 being the credit I took in to establish the spread. If I also still held the bear call credit spread in this example at expiration, I would keep all the credit that I had collected for that spread, but it wouldn't offset that large loss for the violation of the sold put strike.

A calculation of the exact loss in this hypothetical example would be as follows: On the remaining 20 contracts of JAN 510/500 bull put credit spreads, I would have lost $8,800 [($5.00 - 0.60 original credit) x 20 contracts x 100 multiplier]. If I hadn't previously adjusted or closed them, I'd keep all the profit from the remaining 25 contracts of the bear call portion. That would be $1,450 [($0.58 original credit) x 25 contracts x 100 multiplier]. The loss on the bull put credit spreads would also be offset by the $200 credit I'd locked in on the 5 contracts that I closed for $0.20 ([$0.60 original credit - 0.20 debit to close] x 5 x 100 multiplier]. My total loss in this hypothetical situation would have been $7,150 plus commissions. That shows how wrong these condors can go. The hypothetical loss of course would have been much larger if, in this hypothetical situation, the SPX had settled at 501, and I still had all 25 contracts of my original bull put spread.

When I enter credit spreads, I usually sell strikes with deltas of about 0.06-0.07. The delta values, available through most brokerages, help traders figure out the probability of a trade being successful. An option with a delta of 0.06, for example, has about a 6 percent chance of being in the money at expiration. Credit spread traders don't want that sold option to be in the money at expiration, though. They're glad to know that an option that has a 6 percent chance of being in the money at expiration has a 94 percent chance of being out of the money at expiration. When I'm selling credit spreads with the delta of the sold strike at 0.06 or 0.07, those credit spreads have about a 93-94 percent chance of being profitable at expiration (100.00 - 0.06 or 100.00 - 0.7). They have a high probability of success at expiration.

Traders should realize, however, that the 6 to 7 percent chance that these credit spreads will be violated at expiration is not the same as the probability that the sold strike will be touched sometime after the trade is initiated and before expiration. There is a higher probability than 6 to 7 percent that the sold strike will be touched during that time.

If I know that there's a higher probability that the sold strike will be touched than that it will be violated at expiration, I might approach these trades differently, depending on whether I'm a conservative trader or an aggressive one. If I'm a conservative trader, which I am in fact, then I might want to close these credit spreads at the earliest opportunity, giving up some of my original credit so that I don't stick around long enough for that slightly higher probability touch before expiration. If I'm conservative, I know that if the sold strike of my credit spreads is approached, I'm going to have to make a tough decision, and I'd rather not make that tough decision. I take any opportunity to exit a credit spread and lock in most of my credit. A credit spread that seems safe one week may be anything but safe a week or two later.

Of course, I'm going to have to give up some of the original credit I collected to lock in the rest. How much of that original credit is given up is up to the trader, and but it should perhaps also be somewhat dependent on the market behavior. For the last year, with market action so unpredictable, I've been willing to give up quite a lot of my original credit. In fact, the last few months, I've been willing to give back up to $0.20 out of the original $0.60 or so that I collected. I'm giving up more profit than most credit-spread traders want to give up, but in this environment, I just want to collect a profit and get out. I put an order out every day for all my credit spreads to exit, just in case an opportunity is afforded to exit, but particularly for the bull put spreads. You never know. That's why on December 5, I had only 20 contracts of the bull put portion of my JAN SPX condor. I was surprised when, on 12/1/2008, I got a partial fill for 5 of the original 25 JAN 510/500 bull put spreads.

By 12/08, I had closed out the remaining 20 contracts, and the average amount of my original credit that I gave up to lock in the rest of the profit was $0.17. By 12/12/08, I had also closed out the 25 contracts of JAN 1110/1120, all for $0.20 on the weakness seen that morning. Well ahead of expiration in a volatile market, my profit--albeit a small one--was locked in.

That's the first tactic that can be used for exiting, this time exiting when a position is going well. Not all traders agree with this tactic. Even if they agree in principle on locking in profit and eliminating further risk, some traders prefer to wait until the credit spread has narrowed to $0.05-0.10. This is my way of dealing with a volatile market situation, yet still trading, and it may not be suitable for everyone. I do encourage all to think about whether they really want to hang onto a big possible risk for the last $0.10 or so of their possible earnings. Every former floor trader I've heard talk about credit spreads says it's nearly impossible to squeeze out that last dime of credit ($0.20 for an iron condor) without holding these into option expiration week and none of these experienced traders wants to hold into option expiration week if they can help it.

Sometimes, when I've exited for a $0.20 debit, I'll be afforded an opportunity later in the opex period to put the same spread back on again for $0.50-0.60 credit, so I don't mind exiting early and locking in a profit. More than once, I've been glad I exited when a previously seemingly safe credit spread gets into trouble a week or two later.

As option expiration approaches, I tend to pull in the debit I'll offer to close these, with the hope that I can eventually exit them for a dime. I always, always take any opportunity to close for a dime, however, following the advice of those previous floor traders, people who always work to manage risk.

That's how a conservative trader might deal with the knowledge that there's a higher probability that a sold strike in an OTM credit spread will be touched than that it will violated at expiration. How would that knowledge be dealt with by an aggressive trader? Perhaps much differently, as it turns out.

Looking at the fact that these are high probability trades, that they usually have an 85-95 percent chance of success at expiration, depending on the style of the credit-spread trader, some traders will just gut it out and let them run to expiration, taking their chances that their credit spreads or iron condors will be safe at expiration. Some pundits consider that a valid tactic, but there should be some caveats. The most important one to me is that, if you're going to choose that tactic, you have to choose it all the time.

If sometimes you're going to gut it out and sometimes you're not, the times you gut it out may well be the times that the sold strike is deeply violated at expiration, and the times you decide to go ahead and pay the debit and exit may well be the times that the markets are going to bounce back away from your sold strike, and you didn't need to exit at all. I consider myself a fairly good technician, but even I can't always tell when a cascading-lower or soaring-higher market is going to suddenly stop and obey support or resistance levels.

If a trader always puts on credit spreads or iron condors with 85-95 percent probability of success, then those trades should be successful 8.5-9.5 times out of 10 trades. If a trader therefore embraces the idea of letting what happens happen, that trader is going to make fairly good money 8.5-9.5 times out of 10 tries, on average.

However, the ones that go wrong are going to punish such traders, maybe big time. For example, although I have closed out all positions in my original JAN SPX iron condor, locking in my profit, let's go back to that earlier "what if" example from the time when this article was originally roughed out on December 5. As noted earlier, the damage in that example for a credit spread with a sold strike violated by only 5 points at expiration was $7,150 plus commissions.

If I regularly traded 25 contracts of iron condors with credit of about $1.18, as this one took in, and those followed their expectations of profit for 8.5-9.5 months out of 10, my account would still show a profit, but it would take about 2.4 months of profits to make up that hefty loss. That seems a heavy toll to me even if far more trades are profitable than losing ones.

There's a problem in this whole "expectations of profit for 8.5-9.5 months out of 10" statement, too. While we might expect these trades to be profitable 8.5-9.5 months out of 10, that's over a long, long sampling of such trades. That does not mean that we can expect that in any given single ten-month period, we can expect 0.5-1.5 bad trades and 8.5-9.5 good ones, and then repeat that performance the next ten months. That means only that over hundreds and hundreds of such trades, we can expect losing trades to average 8.5-9.5 out of every 10. Somewhere in that record of hundreds and hundreds of such trades, there may be a winning streak that lasts 20-30 trades long. Somewhere in that record of hundreds and hundreds of trade, there may also be a losing streak that goes 5 trades long.

I don't know about you, but I can't easily weather the emotional impact of losing something in the range of $7,150 five months in a row. My account is big enough to weather it, but I couldn't withstand it emotionally. My confidence in myself as a trader would be seriously eroded. Mathematically, I would understand that this is the way probabilities work and that I was no worse a trader than I had been before, but "mathematically" and "psychologically" are much different.

Therefore, evaluating exit strategies requires some self-knowledge. Traders should not feel over-confident if they have a 90 percent record of profitable to unprofitable trades over a significant enough number of such trades. They should have that kind of record once the sampling of such trades is large enough. That's what the probability calculations show if they're going to be selling iron condors with probabilities of success of 85 to 95 percent. However, neither should traders let losses too big for their psychological comfort zones occur. If a trader's account and confidence levels can weather a number of big draw downs in a row, then some could reasonably argue that letting these high-probability credit spreads or condors play out is a legitimate trading strategy, but only then. Such traders would willingly accept the infrequent large loss, knowing that statistically, such losses will be recaptured by a greater number of winning trades over a large-enough sampling of such trades.

But, my question is, why would you weather it anyway, if there's something else you can do? The next article will discuss some of those "something else" solutions I've culled from my attempts over the last couple of years to find the right exit strategy for my comfort zone. Some suggestions will fit your needs as a trader and some won't, but I hope all will start you thinking.

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