I don't get bull put spread risk/reward

[FrankSlaughtery]

Robwynge - re just buying the UL and setting a reasonable stop...this works until there is a gap. Obviously more of a prob for individual stocks than indices but it can (and does) happen w/ them too (9/11, any rogue swan, etc.). So either accept this risk or hedge (allocate small amount of capital to long OTM put options and look at them as cost of doing smart business).

Re being "pretty damn sure" about something is a very dangerous way of thinking. If I told you on 9/10 that I was pretty damn sure there would not be the biggest terrorist attack in history tomorrow so I will sell a bunch of naked puts niederhoffer style well...

I'm not trying to be critical just pointing out that just b/c a risk is small doesn't mean it can take you out.

 

[Robwynge]

Frank,

Thanks for you caution. I am still trying to think about risk/reward in the options context, so all advice is greatly appreciated. Yes, the thing I worry about is a true sudden black swan, the kind of thing that happens overnight and there is no way out my position until market open, which has gapped down hugely. In fact, things like the financial crisis and the Japan earthquake don't really bother me much because I feel there is plenty of time to get out (I was out by summer of 2008 before the big crash and I canceled my long trade when the earthquake hit at 1.5% loss).

However, for a true sudden black swan, sthis eems to be an issue regardless of whether I choose an options approach of selling deep OTM puts or whether I go long the underlying with a stop. Isn't this the case?

If anything, it seems that finding deep OTM puts is somewhat safer because unless the market truely crashes massively overnight (what would it take to knock the S&P down down below 1200 overnight?), there is sometime to unwind the position before the maximum loss is reached. Howver, I get that even with that larger margin of safety, it is still possible to take the full loss, so the spread between the two legs needs to keep the loss to a surviable amount, perhaps under 10%? It would seem that to keep the losses to no greater than 2% would make it impossible to have a positive expectancy in a system where the reward is also capped at such small amounts.

So again, my current thinking is that is seems there is a choice between systems that have 95% small offsetting wins and losses but 5% larger winners that pay for everything, or a system with 85% small winners and then 5% larger losers. There may be some other issues I have not factored in, but this seems a matter of trading preference to me at this point.

If I have this totally wrong, please let me know!

Thanks again!

 

[AAAintheBeltway]

The issue is not risk:reward but expectancy. Win percentage is far more important than in trading a trend following or vol breakout system.

Another issue is avoiding the max loss. You really have to trade these spreads and not just sit there and let them go out with a max loss. That is the killer.

An advantage of doing credit spreads is you often get to expire them worthless, which really lowers your cost. One of the problems in trading options, at least for retail traders, is giving up the spread twice. Transaction costs can become too high a percentage of total profit.

Vertical spreads are a directional strategy, despite what some of the education gurus might teach. You have to be able to trade the underlying, and there is no free lunch. Many people try these and conclude it is easier and more efficient just to trade the underlying directly.

 

[spindr0]

Quote from Robwynge:

I get the analogy, but black swans are black swans, if things are bad enough to take out 1200/1980, they take out ATM put spreads way sooner. At least with far OTM, there is time to bail out before you have to take the full loss.

I usually swing trade stocks and futures, so I actually think I have a directional edge with a R:R that involves reward exceeding risk. If I really felt good about a trade, I would think it makes more sense to just buy the underlying and set a reasonable stop (if any options junkies want to explain why that thinking is wrong, I'd be glad to listen). The idea for OTM options is for extra income or as a back-up plan when I feel less certain about direction.

There are many ways to skin the cat. Here are but two:

A way to possibly improve the R/R of spreads is to leg in incrementally, particularly if you have some degree of "directional edge". For example, if 10 naked puts is you comfort level, start there and if the UL moves up, buy 15 of the long leg one strike lower or the same strike a month later (diagonal). If the UL moves down, add 10 more NP's and so with subsequent zig zags. If naked isn't comfortable, buy 5 long then sell 10 short, etc., continually adding. Either way, you build a larger position at more favorable prices.

If black swans are your concern, buy some OTM index puts as portfolio protection. If the cost intimidates you, you can mitigate some of it by selling some OTM naked calls or OTM bearish call spreads. Your big gains come from your trading edge and good money management. The option component is catastrophic insurance.

IMHO, options are much tougher to win with than trading the UL because the multiple legs have more slippage and commissions as well as their reduced delta (even lower with spreads). You have to utilize what suits your trading abilities.