Credit Spreads- Horrible Risk:Reward?

[tommo]

Are you directional when you trade futures? Trade Credit spreads same way, I tried for few years of doing it strictly on the Greeks and couldn't find that sweet spot, but when I had taken trading systems for the underlying and trade credit spreads instead, working like a charm for me, but you do have to figure out a way of when trade not going as expected as a way to get out at breakeven on losing trade.

Yeah that makes a lot of sense actually, to be honest most of my futures trading is mean reversion/spread trading these days. But can see how options are good for directionals.

What percentage of your trades would you say you can turn what would have otherwise been a loser into a break even in the options? Is that normally done by putting on another credit spread further out?

 

[drcha]

These verticals are hard to adjust because there is no profit in them until near expiration, when it becomes expensive to adjust. For directional trades, it's best to make your decisions based on what you think about the UL.

 

[Handle123]

Yeah that makes a lot of sense actually, to be honest most of my futures trading is mean reversion/spread trading these days. But can see how options are good for directionals.

What percentage of your trades would you say you can turn what would have otherwise been a loser into a break even in the options? Is that normally done by putting on another credit spread further out?

I been trading futures since mid 80s and stocks before this, except for trend trading, I think many start a trade with reversion to the mean when many are buying dips but they don't see it as such. I started learning how to trade options as an investment at same time of learning more in depth of spread trading 3.5 years ago to help my best buddy. I been using options long time as a hedge in stocks/commodities so am deep in knowledge on how not to hurt myself. If I said the percentage to the world of how I redeem bad trades, 99% think BS, so I won't. But 7 years ago something happened to me as almost lost my life and changed how I trade now. So I think in terms of risk first and never profit, it has change the bottom line incredible for me. I even hedge my spreads.

 

[ironchef]

Are you directional when you trade futures? Trade Credit spreads same way, I tried for few years of doing it strictly on the Greeks and couldn't find that sweet spot, but when I had taken trading systems for the underlying and trade credit spreads instead, working like a charm for me, but you do have to figure out a way of when trade not going as expected as a way to get out at breakeven on losing trade.

Handle,

I have until now mainly traded long or short options.

A lot of options books I read (e.g. Get Rich With Options by Lee Lowell was one) claimed spreads were the best options trading strategy and were the "bread and butter" trades of professional traders.

You are saying to be successful it is still a directional trade? With spread, it is not easy to work out the probability outcome, especially the combination of changes in direction, volatility and time decay. Do you have any suggestions?

I welcome others to chime in.

Thanks

 

[quant1]

Handle,

I have until now mainly traded long or short options.

A lot of options books I read (e.g. Get Rich With Options by Lee Lowell was one) claimed spreads were the best options trading strategy and were the "bread and butter" trades of professional traders.

You are saying to be successful it is still a directional trade? With spread, it is not easy to work out the probability outcome, especially the combination of changes in direction, volatility and time decay. Do you have any suggestions?

I welcome others to chime in.

Thanks

I'm not sure when that book was written, but I'd bet 90%+ of professional option flow is in the following forms:

- market making which is done delta neutral
- volatility arbitrage: computing a vol surface and trading reversion towards the mean in volatility space. Delta hedging is done here as well
- volatility dispersion: basically a stat arb between two correlated underlyings and their respective volatility. Also delta neutral.

I would find it odd for a pro desk to think in terms of credit spreads because it's unlikely that a trade involves vol reversion just between two options in the chain.

However, I know there are hedge funds and banks that have taken large, direction plays in options, but this is in the realm of betas.

 

[garachen]

I am an experienced futures trader but am looking to supplement with options and been looking into credit spreads

Below is the options chain for the Eurostoxx

Im looking at doing a credit spread on the put side.
The 3200 strike has a delta of -21.50 so around my sweet spot in terms of probabilities and offering 19.6 ticks in premium (196 euros credit)

But looking at the strike prices around it, how wide would you typically make a spread? Im thinking of buying the 3100 put which will give me a total of 11 ticks for this credit spread (19.6 ticks for the 3200 strike - 8.7 ticks for the 3100 strike = 11).

So basically I am risking 100 ticks (1000 euros) to make 11 ticks (110 euros) with roughly an 80% chance of winning based on implied vol. That seems like a pretty horrible trade, if i make 100 euros 8 times out of ten and lose up to 1000 euros the other 2 times (on average) im probably break even at best. But more than likely out of pocket. EVen if I had a great market timing edge and got that up to 90-95% win rate im still around break even


I appreciate volatility is very low at the moment. But even so, the probabilities of reaching each strike price are relative. Am i missing something? Does that mean there are no trades to be done here?

Is the edge in how you handle credit spreads going offside.. rolling them, butterflying them etc. Because just on its on, left to expiry based on the numbers i have outlined is a bad strategy

Would really appreciate some clarification

Your calculations as stated would make this seem to be a horrible trade. It's the approximations which are making it look so bad. You are using max risk and max reward when a very likely scenario is a payout of < 11 or a loss of < 100. Adding those together gets the trade back to a net positive expectancy as long as realized vol <= implied vol.

Overall, I don't think it's a great time to be selling vol.

 

[drcha]

I'm not at all sure that, over time, credit spreads have positive expectancy. However, if you have some reliable (better than chance) way of predicting the direction of the underlying, then you can make them have positive expectancy.

 

[ironchef]

- volatility arbitrage: computing a vol surface and trading reversion towards the mean in volatility space. Delta hedging is done here as well
- volatility dispersion: basically a stat arb between two correlated underlyings and their respective volatility. Also delta neutral.

Can a retail mom and pop trader do volatility arbitrage and dispersion? What do I have to do to learn that?

Regards,

 

[quant1]

Can a retail mom and pop trader do volatility arbitrage and dispersion? What do I have to do to learn that?

Regards,

While these trades tend to happen in high frequency, I think there may be a sort of pairs trade on vol that retail traders can take advantage of. It would involve finding a pair of correlated instruments (say for example SPY and IWM) and then computing whether the difference in normalized volatility is close to zero. If not, you sell vol for the overpriced option and buy the cheaper vol. imagine a sort of iron condor with short legs in the overpriced product and long legs in the underpriced one. The valuation details would need to be worked out

 

[stevegee58]

I'm not at all sure that, over time, credit spreads have positive expectancy. However, if you have some reliable (better than chance) way of predicting the direction of the underlying, then you can make them have positive expectancy.

No they don't, at least not in general.

Expectancy = (Probability of Win * Average Win) – (Probability of Loss * Average Loss)

You have to mathematically work out the expectancy for every candidate trade. If the IV smile is flat then credit spreads work more in your favor. If the IV smile makes the long put relatively more expensive then it takes away profitability.

Don't confuse high probability with positive expectancy. Probability is only one factor in expectancy.