Credit spread - deep otm - false sense of security?

[hedgeman]

Quote from optionstrading:

Thanks. Very, very interesting trading strategy. Can you explain a bit more about how volatility will affect this position? Let's look at some different scenarios with a couple of weeks having past (i.e. when we get to about Sept 12th):

1 - Vol is unchanged. Looks like you will be showing profits within a range of about 760 to 830. Not bad. But, you will show massive profits on a break below 600 or above 905.

2 - Vol is up 5%. Showing profits above 780 and massive profits below 615 and above about 850. As vol increases, your vega increases, I assume this is because you have positive vomma? Can you please confirm?

3 - Vol is down 5%. Showing profits between 745 and 845. Massive profits below 595 or above 915. As vol decreases, your vega decreases, I assume this is because you have positive vomma? Can you please confirm?

4 - Vol is up 25% due to a tail event. You are profitable within any range with profits increasing exponentially below about 670.

Very interesting strategy indeed, and I do love the fat tail protection. I have a couple of questions in addition to the ones above if you don't mind.

a) What are the downsides to this strategy? Obviously there is huge upside in the case of a fat tail event, but what can hurt this strategy? What is your worst scenario?

b) What's your plan for managing the trade? Adjustments, stop loss, profit target etc.

c) Do you have any criteria for trade entry, or is this something that you put on each month no matter what? Does the current vol levels determine how much tail protection you buy?

d) Anything else i'm missing?

Thanks very much for sharing and providing advice.







Since tail

Yes, the goal is to maintain a positive vomma. I stress test the trade by adding/subtracting vol, price and add time. The trade will usually start off with a slightly neg theta but this is not a concern. Neutralizing vega is the key.

My first adjustment, if you want to call it that, is adding/doubling the size of the trade, so it'll have a similar profile but with different strikes since the market is always moving.

I start taking it down a couple weeks or so prior to expiration or when the opportunity to close a few shorts at a time makes sense.

I like the 10 point spread on the call side and 20 on the puts. There is no magic to back ratios only that it is a much safer trade than iron condors.

Adjustments or additional trades are done after I give the trade some time to breathe and get an idea on direction. There are many adjustments to mention.

Try putting some on in your paper acccount to get a feel for them. Good luck.

 

[Put_Master]

Quote from hedgeman:

For the covered call sellers. I know its another popular strategy, buy/write but as you know this has the same risk as selling puts naked. This is another strategy that can wipe you out in a bear market.

Think about what your risk is on the trade. If I traded this way and wanted stocks, I'd be buying deep in the money, far out, say 6 months to a year+ puts for protection and thereby limiting risk, THEN selling the out of the money front month calls. You could potentially be in a riskless trade if your timing is good and you dont' fall asleep.

Thats another good way to stay in the game and prudent way to protect your stock portfolio and sleep soundly at night knowing that you are covered. Trading covered calls is for suckers anyway. Thats just reality.

I agree that a strategy of selling calls is for suckers.
But only if that is your initial strategy for getting in the market.
That being, buying long and then selling a covered call sometime after you already own the stock.
I don't think it's a sucker strategy if you sell calls as a result of having stocks put to you at your desired strike.
A buy/write strategy is different, because you get to preselect your stock price, your credit and break even point, BEFORE the trade is even initiated.
HOWEVER, it assumes you use that ability "intelligently", to plan ahead for difficult times,... by preselecting a very good price, a reasonable credit and a potentially recoverable BE price.

As for your comment about a buy/write potentially putting you in a position to be wiped out in a bad market:
It's actually one of the few strategies that will keep you from being wiped out.
Because you are not betting against a time clock and potential time bomb of your contract expiring, and you are unlikely to be on potentially "excessive margin leverage", that you are more likely to be on via other strategies like credit spreads, naked puts, ect....

As for being in a potentially riskless trade via protective option strategies, the only way to potentially do that, is to put yourself at severe risk sometime during your trade prior to being protected, and/or adding additional TIME risk to your trade, being on potentially excessive leverage, and/or accepting a rather puny single digit annualized % return on the trade.
Or am I mistaken?

 

[hedgeman]

Quote from Put_Master:

I agree that a strategy of selling calls is for suckers.
But only if that is your initial strategy for getting in the market.
That being, buying long and then selling a covered call sometime after you already own the stock.
I don't think it's a sucker strategy if you sell calls as a result of having stocks put to you.
A buy/write strategy is different, because you get to preselect your stock price, your credit and break even BEFORE the trade is even initiated.
However, it assumes you use that ability "intelligently", to plan ahead for difficult times,... by preselecting a very good price, a reasonable credit and a potentially recoverable BE price.

As for your comment about a buy/write potentially putting you in a position to be wiped out in a bad market:
It's actually one of the few strategies that will keep you from being wiped out.
Because you are not betting against the time clock and time bomb of your contract expiring, and you are unlikely to be on potentially "excessive margin leverage", that you might be on via other strategies like credit spreads, naked puts, ect....

As for being in a potentially riskless trade via protective option strategies, the only way to potentially do that, is to put yourself at severe risk sometime during your trade prior to being protected, and/or adding additional TIME risk to your trade, and/or accepting a rather puny single digit annualized % return on the trade.
Or am I mistaken?

Hi, on what I think about covered calls, its how I started, so I know this strategy will pull new traders in to buying stocks just to sell calls against them. So, I was a sucker too. ha.

When you have a stock put to you, this is probably not a good sign for the stock. If you sell calls against your stock, you might wiggle your way out of the position but the downside is huge. The stock could continue its downward spiral and each month you are collecting less and less premium since the stock price is declining. OR, after having the stock put to you, you sell calls only to have the stock gap up and then you have a loss on your calls. Its a dicey situation to be in.

Your last paragraph I believe is referring to how you could potentially have a risk free trade and only upside. Yes, its possible without the severe risk you mention. Actually, its the opposite. I mentioned buying stock covered with far out puts, then selling out of the money front month calls or call spreads. Yes the returns are not great but its a sleep at night way to trade for those that have stocks.

 

[hedgeman]

Quote from optionstrading:

One other question, since tail events typically occur on the downside, why are you trading the extra calls on the long side? Wouldn't it be better to just buy the same number of calls that you are selling?

The market can continue to rip higher, so you have protection on the upside as well.

 

[Put_Master]

<<< When you have a stock put to you, this is probably not a good sign for the stock. If you sell calls against your stock, you might wiggle your way out of the position but the downside is huge. The stock could continue its downward spiral and each month you are collecting less and less premium since the stock price is declining. OR, after having the stock put to you, you sell calls only to have the stock gap up and then you have a loss on your calls. Its a dicey situation to be in. >>>

It's obviously not a good sign for the stock if it's put you you, but your potential loss is reduced via calls, and thus the huge downside risk you mentioned is reduced.
Are you suggesting it's better not to consider selling calls, if a stock is put to you?
Personally, my strategy for selling calls when a stock is put to me, is to first consider selecting a strike that would lean towards "neutralizing" the trade gone bad.

That being, if a stock is put to me at $40, and is now trading below $40, I would first consider selecting a strike BELOW $40 to sell a covered call on.
Once stock is put to me, my goal changes from being profit driven to being BE driven.... give or take a little.
My goal now is to get back into cash, so I can return to picking my strikes and investing with an otm safety cushion.

 

[hedgeman]

Quote from Put_Master:

<<< When you have a stock put to you, this is probably not a good sign for the stock. If you sell calls against your stock, you might wiggle your way out of the position but the downside is huge. The stock could continue its downward spiral and each month you are collecting less and less premium since the stock price is declining. OR, after having the stock put to you, you sell calls only to have the stock gap up and then you have a loss on your calls. Its a dicey situation to be in. >>>

It's obviously not a good sign for the stock, but if anything, your potential loss is reduced via calls, and thus the huge downside risk you mentioned is reduced.
Are you suggesting it's better not to consider selling calls, if a stock is put to you?
Personally, my strategy for selling calls when a stock is put to me, is to first consider selecting a strike that would lean towards "neutralizing" the trade gone bad.

That being, if a stock is put to me at $40, and is now trading below $40, I would first consider selecting a strike BELOW $40 to sell a covered call on.
Once stock is put to me, my goal changes from being profit driven to being BE driven.... give or take a little.
My goal now is to to get back into cash, so I can return to picking my strikes and investing with an otm safety cushion.

Yes, I would go along with selling an in the money call if assigned as you mention, or better, just sell the stock and move on. Its just when you see a bear market, and have a large exposure, you're going to get torched trading this way. They come along quickly and all stocks suddenly get taken out to the wood shed and in large % moves. Just how I see it.

I would encourage anyone to take their strategy and see how it would have performed by doing some backtesting to last year or '08. Its worth the effort.

 

[Put_Master]

<<< Very interesting strategy indeed, and I do love the fat tail protection. I have a couple of questions in addition to the ones above if you don't mind.

a) What are the downsides to this strategy? Obviously there is huge upside in the case of a fat tail event, but what can hurt this strategy? What is your worst scenario? >>>


Not to be overly picky, but i noticed you did not answer optionstrading's most important question above.
Leaving out that detail, is like someone talking about the benefits of having limited losses via a spread strategy, but leaving out the detail, that the so-called "limited loss" may be your "entire accounts value".

My point is, if you are going to encourage others to consider a strategy, you really should speak to its "potential downside", just as you speak of its potential upside and benefits.

 

[Put_Master]

<<< Your last paragraph I believe is referring to how you could potentially have a risk free trade and only upside. Yes, its possible without the severe risk you mention. Actually, its the opposite. I mentioned buying stock covered with far out puts, then selling out of the money front month calls or call spreads. Yes the returns are not great but its a sleep at night way to trade for those that have stocks.>>>

When you speak of % returns "not being great", is it reasonable to assume, if you don't take on the additional risk I discussed, then you mean the likelihood of investing for "single digit" annualized % returns?

 

[hedgeman]

Quote from Put_Master:

<<< Very interesting strategy indeed, and I do love the fat tail protection. I have a couple of questions in addition to the ones above if you don't mind.

a) What are the downsides to this strategy? Obviously there is huge upside in the case of a fat tail event, but what can hurt this strategy? What is your worst scenario? >>>


Not to be overly picky, but i noticed you did not answer optionstrading's most important question above.
Leaving out that detail, is like someone talking about the benefits of having limited losses via a spread strategy, but leaving out the detail, that the so-called "limited loss" may be your "entire accounts value".

My point is, if you are going to encourage others to consider a strategy, you really should speak to its "potential downside", just as you speak of its potential upside and benefits.

Downside, well, you could hold onto short positions 'til the bitter end and risk a max loss, this would be very irresponsible right? After all, this trade does ultimately have the the same max loss as an iron condor. If the market is coming after your shorts, well, you have to adjust, which means you will eat into your credit. There is no holy grail, I think even a novice can figure that out. The trade set up from the beginning is safe but the holding period can be long.

By the way, this is how I like to trade but this is likely not for you. You should stress test your own trades and trades like the back ratios that I have talked about. As I mentioned in a previous post, backtest last year and in 2008 any strategy that you like or that you are trading currently. Don't read my posts and think I am the know it all, do the work, its worth the effort. Some one had asked me for an example, and that is what I provided.

 

[hedgeman]

Quote from Put_Master:

<<< Your last paragraph I believe is referring to how you could potentially have a risk free trade and only upside. Yes, its possible without the severe risk you mention. Actually, its the opposite. I mentioned buying stock covered with far out puts, then selling out of the money front month calls or call spreads. Yes the returns are not great but its a sleep at night way to trade for those that have stocks.>>>

When you speak of % returns "not being great", is it reasonable to assume, if you don't take on the additional risk I discussed, then you mean the likelihood of investing for "single digit" annualized % returns?

Sure, its possible for a covered stock trade to have single digit returns. There are other trades that could enhance returns.

The risk you discussed is selling puts on stocks you like. Then covered calls if assigned. Correct? I'd go with covered stock/married puts. If you are sitting there with a portfolio of short puts, those single digit returns are going to look pretty darn good in a bear market.

Just my opinion, trade as you are comfortable and confident. I have my own style and confidence in my trading.