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Trader's Corner

Exploring Adjustment and Exit Strategies for High-Probability Credit Spreads and Iron Condors: Part 2

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Last week's Trader's Corner dealt with exit strategies for high-probability credit spreads or condors. For the rest of this article, assume that any mention of credit spreads or condors references those with a high probability of success. These would include credit spreads or condors in which the sold strike had a delta of less than about 0.10 (or 10, if you prefer the figure with the multiplier applied) when the trade is opened. I prefer a delta of 0.06-0.09.

Last week's article introduced a topic that some traders of these high-probability spreads or condors might not have previously considered: there's a higher probability that a credit spread's sold strike will be approached or violated sometime before expiration than that it will be violated at expiration. This reflects the fact that prices can bounce around, maybe violating the sold strike at some point but often then backing away by expiration.

The article went on to discuss some of the implications of this idea. This idea prompts different choices for the conservative trader and the aggressive one, choices it might be appropriate to review before moving forward with the discussion.

Conservative spread traders might react by locking in profits at the earliest opportunity, effectively limiting any further risk if prices should approach the sold strike before expiration. Wouldn't it be better to lock in profit, if the opportunity presents itself, before that can happen? When a sold strike is approached, conservative spread traders are likely to activate some sort of adjustment or exit strategy, one that's going to cost them money, and some will reason that a smaller locked-in profit is better than the possibility of a loss.

Conservative traders might agree with that tactic, and a surprising number of former floor traders or marker makers agree with it, too. We often think of these people as the true cowboy and cowgirl traders. In truth, most have been schooled by their firms in managing risk. They question the wisdom of trying to eke out the last nickel or dime of collected credit while keeping so much money at risk with a credit spread or condor. These trades have a high probability of success but a terrible risk-versus-reward setup. Most former floor traders or market makers I've heard prefer to close the spread when they have the opportunity to lock in an appropriate amount of profit. They can then put their money to use elsewhere or can spend part of the option expiration period with no risk at all.

How much of their original collected credit are they willing to give up? Most I've heard agree with a dime or $0.20 for a iron condor, and some agree with that price for closing a spread, just one side of a condor. In this environment, I'm getting out of my spreads as soon as I can lock up 60-65 percent of the original credit I collected. That's my choice. Doing so and freeing up my money for another trade certainly helps me manage risk, but it also sometimes allows me to get back into another spread when the market bounces the other direction again.

For example, on December 11, I closed 25 contracts of a SPX JAN 1110/1120 bear call spread. On December 16, as markets were bouncing, I opened 25 contracts of SPX JAN 1080/1090 bear call spreads for $0.60 per contract. Two days later, when markets dropped, I was even willing to spend a little more than my typical $0.20 debit to close out a credit spread. On December 18, I spent $0.21 debit to close the credit spread, locking in my profit for the spread, ready to do it again if the SPX zoomed up high enough, soon enough. That didn't happen, but I made money twice on SPX JAN bear call spreads.

There's a con, of course. Markets might never closely approach a sold strike and the expiration period could have ended with the credit spread never needing to be closed. The full original credit could have been kept. It happens. I don't care. I care more about managing risk. You may make a different decision.

If you're an aggressive trader, you likely will make a different decision. Aggressive traders might react differently to the knowledge that the likelihood of the sold strike being tested is greater than it is that it will be violated at expiration. They might choose to let the high-probability credit spread or full iron condor run, taking their chances that even if the sold strike is violated before expiration, the markets will bounce back away from that sold strike before expiration.

Early in my condor-trading career, I took that tack, but soon after I lost a hefty amount one expiration period, enough to damage my confidence in myself more than it did my trading account, I went looking for other answers. I heard former long-time market makers decrying the wisdom of that tactic, and I changed my ways. Now, the whole thought of letting that risk stay open for the last nickel or dime of potential profit gives me the heebie jeebies. I've seen too many option-expiration week debacles over the last 18 months or so to ever want to go into option expiration week with front-month credit spreads open if I can help it.

Each way of handling credit spreads has its pros and cons, and none is "bad" or "good," but rather appropriate or not appropriate for a particular trader. Letting credit spreads stay open into expiration to collect that last nickel or dime--or, in my case, $0.20--of profit or, conversely, on the hope that markets will bounce back away from a sold strike by expiration subjects credit-spread traders to the occasional huge loss. Such losses take several months of gains to make up.

Other choices exist. Each of those choices costs something and has pros and cons that must be considered. They can, however, if used judiciously, keep losses to a more manageable level when a credit spread is going bad.

I am far from expert in some of these other techniques, but this article and the next will list some of the techniques I have discovered in my two-year study of ways to minimize losses. Some I have tried personally, and others I have not yet personally tested. The ideas were culled from webinars or books presented or written by the CBOE's Peter Lusk, the Options Institute's Brian Overby, Dan Sheridan of Sheridan Mentoring, Steve Lentz, and even from Steven Gail of the Monthly Cash Machine. Gail's MCM is one of the newsletters under the umbrella of the Option Investor name, and he includes a MCM Tutorial that lists some portfolio management strategies for credit-spread traders. Some suggestions have come from my own broker.

This series of articles is intended as a starting point for your own study of the types of adjustments that seem right and appropriate for you and your trading style, account size, risk tolerance and even patience quotient, if you will. It can in no way replicate all the possible permutations of each strategy, so each should be investigated thoroughly before adopting them. I suggest running some through a trade simulator for a few months before adopting them. I also suggest discussing them with your broker.

The first adjustment suggestion my research turned up a couple of years ago came from Dan Sheridan's CBOE webinars. It's a suggestion I've mentioned previously in other Trader's Corner articles: using the delta of the sold strike to tell you when your high-probability credit spread has moved "into the bad neighborhood," as Sheridan often phrases it in his webinars. Sheridan suggests that when the delta of the sold strike has moved to .20-.24 (or 20 to 24 if you're applying the 100 multiplier for each contract of options), your high-probability credit spread no longer has such a high probability of success. He suggests that, if several weeks remain before expiration, it's time for an adjustment. That usually, but not always, includes buying back the sold credit spread for a debit, at a loss, and rolling the credit spread up (in a bear call spread) or down (in a bull put credit spread). If markets are trending strongly, he suggests waiting, perhaps a few days, before rolling into a new spread.

Sheridan does not suggest rolling forward into the next-month period, advice that my broker also offers. Both men suggest that if you're a high-probability credit-spread trader, and you typically sell spreads where the sold strike has a delta of 0.6-0.9, then you should follow the same strategy when rolling. Don't try to turn yourself into a lower-probability credit spread trader just to recoup more of the money you lost by closing out the original spread. High-probability credit spreads and lower-probability credit spreads are treated differently.

My broker further believes that clients should roll up only into the same number of contracts they had before adjusting. The idea is here is that, when adjusting, traders shouldn't take on more risk than they had originally incurred. I confess that I have at times rolled into more contracts, but that was earlier in my trading career and I now keep to the same number of contracts I had originally.

This method of adjusting when the delta of the sold strike is 0.20-0.22 will result in a loss. Let's look at an example of a spread that might have been going wrong at the time this article was first roughed out. For example, on December 12, the RUT JAN 2009 540 Call had a delta of 0.225. Most brokerages provide this information for clients, as does mine.

Theoretical Data for the RUT JAN 2009 540 Call as of 12/12/2008:
[Image 1]

If that call option had been part of a bear call credit spread in which the trader had sold the RUT JAN 2009 540 call and bought the RUT JAN 2009 550 call as a hedge, that trader might have considered adjusting that Friday, December 12, 2008 afternoon. (Note: I did not have this spread and would not have suggested it. This was chosen as an example of a spread that would have been going wrong that day.)

Since this is a hypothetical situation and not an actual trade in my account, we'll have to assume an original credit of $0.60 for this trade, the typical credit I seek when initiating a 10-point-wide credit spread on the major indices. Exiting the trade by buying back the sold 540 and selling the bought 550 would cost far more than that original hypothetic original $0.60 credit collected, however.

Bid/Ask Spreads for the 540/550 Bear Call Credit Spread as of 12/12/2008
[Image 2]

The midpoint of the quotes here is $2.00, but it's unlikely that a trader would have been able to close this spread at the midpoint. It's more likely that it would have cost the trader $2.20-2.40 to exit the spread.

On 12/12/2008, plenty of time still remained until January option expiration, so rolling up into a new JAN bear call spread was possible. Searching for another call with a delta of .06-0.09 turned up the RUT JAN 2009 590 call with a delta of 0.08, but the premium would be low for a 590/600 bull call spread.

Bid/Ask Spreads for the JAN 590/600 Bear Call Credit Spread as of 12/12/2008
[Image 3]

The JAN 580/590 bear call spread was more likely to return $0.60-0.65 credit, but the delta on the sold JAN 580 call was already 0.10, a bit higher than I prefer when initiating credit spreads. The trader would have had a decision to make as neither spread quite fit the theoretical setup I prefer, bringing in about $0.55-0.65 for a spread with a sold strike with a delta of 0.06-0.09. Even if the higher credit offered by the 580/590 bear call spread was chosen, the trader who adjusted the original 540/550 spread by rolling up would lose approximately $1.00-1.20 per contract [$0.60 credit for original spread - (2.20 to 2.40 debit to close it) + 0.60 credit for rolled-into spread].

Why consider doing closing the spread at that point and locking in a loss? If the sold strike has a delta of 0.20-0.24, the theoretical probability that it will be in the money at expiration is still only 76-80 percent [1.00 - (.20 to 0.24) x 100].

However, if the delta is already that high, something is going wrong with the original premise of the trade, Sheridan would suggest. Waiting for that sold strike to be approached more closely would incur a much bigger loss. A look at a spread composed of an ATM strike and one 10 points higher shows the greater damage that would be incurred if a trader waited until the sold strike was closely approached or violated.

With the RUT at 468.43 on December 12, a JAN 470/480 bear call spread can be priced.

RUT JAN 2009 470/580 Bear Call Spread as of 12/12/2008:
[Image 4]

Ouch! That 4.10/6.20 bid/ask spread to exit is much more painful. I want out before I incur that kind of loss.

Of course, if you choose Sheridan's suggested method of adjusting, you'll occasionally be locking in a loss when the markets then turn right around and never approach the sold strike any more closely, and the spread would have been fully profitable into expiration. That's certainly happened to me.

There is no magic highway here, no roadmap that's going to save you from any losses, ever. What this delta-based adjustment guideline offers is a way to judge risk, to determine when you're headed into that bad neighborhood that Sheridan references so often. Sheridan's suggestions offer you a roadmap that helps tell you when you've ventured off the right path and might be getting into those dangerous neighborhoods. It provides a concrete and easily discernable way of telling you when you might begin those adjustments.

As someone who often uses this method, I can tell you that it removes much of the angst of trading decisions, and that's of more benefit than you might imagine if you've never tried it. That's especially true when these types of trades have such a terrible risk versus reward setup. Gone are the days and sometimes weeks when I agonized over whether resistance or support is going to kick in, whether this is the time to close out the trade or whether I'm going to feel stupid if I take the loss right now and markets turn around immediately.

Because losses are smaller, if arguably more frequent, they do not undermine either one's trading account or confidence. I can't emphasize enough that maintaining both--the account and confidence--are of equal importance. Remaining confident keeps one trading during tough times.

If this method is used for a credit spread that is part of a condor, Sheridan suggests that you also roll the opposing credit spread in the same direction you rolled the spread you're adjusting. Because, in that case, you'll be closing out a less valuable credit spread and initiating a new one that's more valuable, this will bring in further credit that will help ameliorate the loss, too.

There's a danger that must be considered in rolling that other side. If markets have been trending so strongly in one direction that they've brought one side of a credit spread into the bad neighborhood, it might soon be time for them to turn around again. Rolling that other side has brought it closer to the action than it was previously. I confess that I don't usually take Sheridan's advice on rolling the other side, at least not immediately. If one side of a condor is in trouble, that usually means that the other one can be closed for a few cents, and I will usually do that. If, after I've adjusted the side that's going wrong, markets turn around and head strongly the other direction, I might then open a credit spread on the other side if I feel I can swing the opposing spread out of harm's way. Again, I usually defer to Sheridan's greater experience, but this is one adjustment that gives me pause.

I would further suggest that you don't have to employ this delta-based adjustment or any other in an all-or-nothing arrangement. I have done this: as the delta of the sold strike has moved through 0.20 and toward 0.24, I have begun stepping out of the credit spreads in portions. If I have a 25-contract position, for example, I might step out of the first 8 contracts when the delta of the sold strike hits 0.21 or 0.22. I might step out of the next 8 contracts as it moves up to 0.22 or 0.23. And I might exit the last 9 contracts as it moves through or past 0.24.

I have at times exited a portion of the position, cutting the risk but not yet taking such a big loss, and then had prices back away from my sold strike again. I then am left with the last 17 contracts of a 25-contract position until time has gone by and I can either close it for $0.10-0.20 or else it's approached closely enough again that I end up stepping out of the rest.

Do I ever regret those losses that didn't have to be, when the markets back off and my spread would have been fully profitable at expiration? Never. Nunca. Jamais. Instead, I pat myself on the back for proving to myself once again that I can follow rules meant to minimize losses. Sometimes I follow those rules despite the fact that I "just knew" prices were ready to turn around. Sometimes prices do and sometimes they don't, but my losses never overwhelm my account any longer. They won't, using this method, unless I wake up one morning and markets have gapped through my sold strike at the open. An unlikely gap of that magnitude would mean that I'd missed an opportunity to adjust. That type of gap is unlikely because it would mean that it would have to be big enough that a sold strike that had a delta of less than 0.20 at the previous day's close was at or in the money the next morning. While that possibility exists, it's unlikely. Other than that type of event leading to a gap, though, this roadmap keeps losses more manageable.

I said that I never regret the times that I used this delta-based method and stepped out of positions for a loss, positions that turned out to be fully profitable at expiration. Did I regret those times when I didn't have this delta-based roadmap and instead let the sold strike be approached or violated before I opted out? Always. Every time. Those losses were big and they hurt.

You have a choice: risk smaller but more frequent losses, some of which didn't need to be taken, or infrequent but account- and confidence-busting bigger losses. I know which choice I make, but you must choose for yourself.

Sheridan offers a variation to this method, a variation that he suggests only in volatile markets. That variation involves purchasing a long option that neutralizes the delta risk and is meant as a short-term hedge only. Other writers such as MCM's Steven Gail mention a variation that would involve buying or shorting stock that would also hedge the delta risk. Unfortunately, this article has grown so long that the discussion of that tactic and others must wait until next week.

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