Option Investor
Trader's Corner

Exploring Adjustment and Exit Strategies for High-Probability Credit Spreads and Iron Condors: Part 3

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For the last two weeks, Friday Trader's Corner articles have explored adjustment theories and strategies for high-probability credit spreads and iron condors. Last week's article introduced the theory of using the delta of the sold strike to indicate when an adjustment might be needed.

In many of his webinars for CBOE and the OIC, Dan Sheridan suggests adjusting credit spreads or condors beginning when the absolute value of the delta of the sold strike reaches 0.20-0.22 (or 20-22 if the delta is multiplied by the 100 multiplier for most options contracts). One way to adjust was mentioned last week: taking off the position and rolling it further away. This adjustment will typically result in a loss.

However, the benefits of this strategy include a smaller loss than might be incurred if the spread is not closed until the sold strike is violated. That loss is typically a heavy one. Another benefit is the confidence gained in knowing when and how to adjust a position. The importance of that confidence can not be underestimated. Confidence allows traders to keep going through difficult periods.

One con is that sometimes a position is adjusted and a loss locked in, only to have the markets reverse and move away from the sold strike. Losses may be smaller but they may also be more frequent than simply waiting to see whether the sold strike is violated before adjusting. I have not back-tested that conclusion so can not verify it using anything but anecdotal evidence.

This article moves the list of possible adjustment strategies forward with another Sheridan-suggested possibility. Sheridan suggests a variation on the rolling technique. This second technique is to be used only when markets are particularly volatile and there's time to adjust before expiration. This wouldn't be a day-of-expiration adjustment, for example. Sheridan would use the same delta-based decision points to determine when a position was in trouble, but he would just do something different once that position wandered into his proverbial bad neighborhood.

This adjustment requires calculating the delta of the entire credit spread or iron condor. Many brokerages will calculate this automatically for you. My brokerage doesn't do it by position but does do it by underlying. I'll show an example. On December 18, after closing out all positions except for one RUT JAN bear call spread in one of my trading accounts, my brokerage's calculation of the Greeks for all RUT positions then was in fact the calculations appropriate to that particular credit spread.

Screen Capture: Greeks of a RUT JAN 2009 590/600 Bear Call Spread on 12/18/2008:
[Image 1]

As you see, the delta of the sold strike 590 strike was rounded off to 0.05 for screen display purposes, and the delta of the hedging long 600 strike was rounded off to 0.04. For position calculations, the delta of the sold strike will be subtracted and the long strike, added. Without rounding off, the difference between the two was actually -0.019056 so that when the 100 multiplier was applied, the result was -1.9056. That result was multiplied by 25 for the 25 contracts and an answer of -47.64 was obtained for the total delta of the position. All this was calculated automatically by my brokerage, but traders should understand how the numbers were produced.

Obviously, with the delta of the sold strike only 0.05, this position was not in any trouble if deltas were used to make that determination. In fact, a few days later, I was able to close out that position for a small debit and lock in most of my profit.

However, what if a position I'd held had been in trouble? For example, what if on December 18, with the RUT at 479.17, I had held 10 contracts of a RUT JAN 430/420 bull put spread instead of the position that I did hold? The delta on the sold 430 strike was -0.2171 (-21.71 with the 100 multiplier) that day, so that position would have been reaching a decision point. Here is how the delta of the whole hypothetical position would be calculated, with figures accurate as of December 18:

RUT JAN 430 Put
Delta -0.2171 or -21.71 with 100 multiplier
10 contracts = Delta of -217.10

RUT JAN 420 Put
Delta -0.1805 or -18.05 with 100 multiplier
10 contracts = Delta of -180.50

Position Delta
-(-217.10) + (-180.50) = 36.60

The -217.10 is subtracted, resulting in a positive value, since that option was sold. What the resultant 36.60 for the position tells us is that this position is delta positive. That means that it would gain 36.60 for each point that the RUT gained or lose 36.60 for each one point that the RUT dropped. That is the delta risk that would need to be neutralized.

How would this neutralization occur? Sheridan suggests that the trader go out one month further and buy a long position that neutralizes the delta. So, in this hypothetical case in which a JAN put position would be approaching a delta-based decision point, I would have needed to buy a FEB put position that would have a delta of approximately -36.60.

When deciding what or how many puts to buy, Sheridan offers a further suggestion. He suggests that the trader buy one long option for each 10 contracts of the credit spread, finding the option combination that would neutralize the delta risk. In the above example, I had hypothesized a 10-contract credit spread, so I would then have been looking for a single FEB put with a delta of about -0.366 (or -36.60 after the 100 multiplier was applied).

As of December 18 when this article was roughed out, a RUT FEB 460 put had a delta of -0.3818 or -38.18 after the 100 multiplier was utilized. If, in this hypothetical situation, I had bought 1 contract of the RUT FEB 460 put on December 18 while still holding that hypothetical RUT JAN 430/420 bull put spread, the total position delta could then be calculated. It would be -1.58 (-38.18 long put position delta + 36.60 credit spread delta). The delta risk would be nearly neutralized, at least until the RUT moved enough that the deltas changed appreciably.

Sheridan then suggests that the trader hold the hedging long option until the absolute value of the delta of the sold strike on the credit spread drops below 0.15 (or 15, with the 100 multiplier) again. He suggests that the purchased hedging option wouldn't lose much during that change. Of course, "much" can be a relative term. Remember, too, that this is a suggested hedge only for volatile markets, so any move back, if it occurs, would occur in a relatively short period of time and little time premium decay would occur. Strictly speaking, perhaps the situation on December 18 would not have met this parameter. The RVX, the RUT's volatility indicator, ended that day at 55.13, which is way out of normal bounds but still trending far down off October, 2007 and November, 2008 highs. Volatility was lower than had been seen in recent times, not higher. Still, since this was a judgment call, let's go forward for instruction purposes.

What has been accomplished by hedging the delta risk in a credit-spread gone wrong? For a certain number of points at least, the delta risk--the risk due to price movement--is neutralized and little loss is incurred as a result of a movement in the RUT's price. Since this is a tactic that Sheridan suggests is appropriate only for volatile times, the thought is that it hedges the position temporarily, allowing the credit spread trader to avoid adjusting the credit spread while the market action settles, hopefully by moving away from the sold strike again. At that time, the hedge is removed.

What are the risks? Several. First, the long option bought to hedge is expensive. That FEB 460 put was bid 32.20 and ask 34.30 at the close on December 18. Expensive options require that traders have the money in their accounts to buy them, of course, but another problem results. These expensive options tend to have bigger bid/ask spreads than cheaper options, so getting between the bid and the ask is important, but perhaps not easy if the market is moving fast. My broker doesn't like spending so much money to hedge a position that brought in far less in credit in the first place. Perhaps your broker won't think it's such a good idea, either.

Second, that hedging long option will work fairly effectively at hedging losses for a while, but it won't hedge a loss all the way through a sold strike. I utilized this method for a different and actual 25-contract bull put position several months ago. I had used the pricer feature on my brokerage's page to calculate the outcome in a worst-case scenario. I knew that if the market went all the way through the sold strike of my credit spread but stopped at the further out-of-the-money long option, the loss for the credit-spread portion would be $25,000, the worst-case scenario. I used that pricer to calculate that the congruent gain from the long hedging purchase would be only $8,000. Of course, if prices continued past both strikes, the long hedge would continue to gain while the loss for the credit spread would top out at $25,000.

In our hypothetical example of a RUT JAN 430/420 bull put spread, imagine that the RUT were to drop through exactly to 420 by JAN option expiration but no further. The hypothetical 10-contract credit spread position would have lost $10,000 at that point. My pricer feature tells me that, with the RUT at 420 at JAN's expiration, that the FEB 460 put would theoretically be worth only about $52.11. If we imagine that a trader could have purchased that hedging FEB 460 put at midpoint between the bid and ask, highly unlikely, the purchase price would have been $33.25. The trader would have then spent $3325 for the hedge, which the pricer indicates would have been worth a theoretical $5211 at JAN expiration with the RUT exactly at 420. The gain on the hedging FEB long put position would theoretically have been less than $2,000 while the theoretical credit-spread position lost $10,000.

To continue hedging the position, then, more FEB 460's would have been needed on the way down in this hypothetical situation. An alternative would have been to keep the hedge in place all the way down while gradually stepping out of contracts of the credit spread, timing each exit to keep the delta risks neutralized. That would require an adept watching of total deltas to decide timing and numbers of contracts to be shed.

There's another problem with this hedge meant for volatile markets, of course. A quick reversal could quickly puncture the premium in the long strike you've purchased to hedge your position. Sheridan suggests holding onto the hedging option you bought until the absolute value of the delta of the credit spread's sold strike moves back below .15 or 15, using that multiplier. For example, with the RUT opening above 485 by December 21, the delta of the JAN RUT 430 put, the sold put in the credit spread, would theoretically have been -.1598 or -15.98 with the multiplier, and the early zoom higher would soon have brought it to -0.15. With that date and opening price input into the pricer, that returns a theoretical value of only $17.61 for the long RUT FEB 460 put. If that hedging long put had been purchased at $33.25, a loss of $15.64 per contract or $1564 for the hedge would have been incurred.

It sounds like a mess, doesn't it? Yet, I've used this method many times, although I confess that I don't always hold onto the hedge until the absolute value of the sold credit spread strike reaches 0.15.

Why and how is this hedge effective? The various calculations show that the hedge doesn't work well as prices closely approach and then begin to move through the sold strike of a credit spread, although it would work better if prices also moved through the other strike of the credit spread and kept going. However, we didn't explore what happens right after the hedge is put on, when it has neutralized delta risk for the time being. At first, it hedges fairly well, so what it does is give traders room to make decisions and, if necessary, to begin stepping out of a going-wrong spread. This isn't a use of the hedge that Sheridan sanctioned, but my own use of it. Far be it from me to argue with Sheridan's greater experience, but I also wanted to mention this change that works for me. I tend to then close the hedge when I've finished stepping out of the credit spread, with the gain in the hedge partially offsetting the loss I locked in on the credit spread.

Sometimes, when markets are bouncing around a bit, neutralizing the delta risk this ways allows me to delay stepping out of positions, watching until the delta of the sold strike approaches 0.26 rather than the typical 0.20-0.22. I have used it when the delta of a sold strike ended the day right at 0.19-0.22 and I was afraid of a gap against the position the next morning. Using it that way helps me sleep at night.

I've occasionally made money on the hedge and occasionally lost it, but what using that hedge has done for me is to allow me that decision time. I am aware of the risks I'm facing and aware that this is not an adjustment technique that's appropriate for all. In fact, my broker considers it rather dangerous because it's such an expensive hedge. My knowledgeable broker's concerns should definitely be factored into your decision making when you're thinking about using this hedge, either in the Sheridan-sanctioned method or in my variation.

If I were trading stocks instead of major indices, I could instead go long or short the underlying as a sold strike was violated, a more complete but even more expensive hedge. However, I can verify from past and traumatic experience that waiting until a sold strike is violated to initiate a hedging long options position, particularly during option-expiration week, is a bad, bad idea. Buying a long option to hedge a credit spread when the underlying's price is still far away is one thing: Buying expensive options under duress and suffering slippage while doing so results in a hedge that is far from complete and perhaps a disastrous idea.

Making delta-based decisions allow the credit-spread and iron-condor trader to determine when trades are veering off into the bad neighborhood and initiate account- and confidence-saving techniques. Each technique has its pros and cons, and I've tried to list them here, but I'm sure I've missed some. The dangers and warnings should not be glossed over but studied in detail and perhaps first tried on a virtual trading platform. I suggest listening to as many webinars as possible through CBOE or OIC and talking over ideas with your personal broker.

I've tried these techniques, and while I'm not sure that I will always continue to use the hedging one listed in this article, I am absolutely sure that I'll continue to adjust or exit high-probability credit spreads and iron condors when the absolute value of the delta of my sold strike reaches into that danger zone. That tactic has moved my trading into the business mode, helping me ensure that my inevitable losses remain manageable.

Next week's article will be a shorter one wrapping up with other ideas I've gleaned from my studies. While I've tried the hedge mentioned in this article, I have not yet tried all of the ideas that will be mentioned in next week's wrap-up article. Still, I thought they deserved being listed for the benefit of traders interested in building a repertoire of adjustment and exit strategies for high-probability credit spread and iron condors.

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