Learning Verticals
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I agree it's basic math. But perhaps new spread investors don't think about the "potential" math.
Just the actual math.
Afterall, when they read that the "benefits" of credit spread trades,.... they're a "protected, cash secured, and limited risk trade".... that sounds like a reasonably safe and simple strategy to impliment.
Simply multiply the strike gap by the number of contracts.
They think they've done the math.
And they have. They've done the "actual" math.
It's just the "potential" math they have not calculated.
And why should they?
Afterall, read any definition and it will describe spreads as a protected, cash secured, and limited risk trade.
Thus, I think it's understandable why a new spread investor may not do the "potential" math, until his trade is in trouble.
All I'm doing is warning about the "potential" math, and how all that "potential leverage" can destroy ones account,... "by limiting your choices for risk management during difficult times".
Now PM and Atticus,
Can I remind you that I am the OP, and that if you want to play in my sandbox, and get the nice toasted sandwiches and hotdogs, you have to place nice.
I am not sure if I completely understand both of you, and whilst I agree with both sides of the picture, I originally asked a question about hedging a portfolio full of credit spreads. Now I am not sure if PM's syntax is accurate, but to his credit, he certainly conveyed a message to me that allowed me to reasses my plan and see a potential risk I never knew I would need to accept.
My plan was only trade cash-secured credit spreads, and whilst PM did not highlight anything new in terms of risk - what he did highlight is that you can't really trade only credit spreads (verticals) and make any reasonable return without leveraging your equity in some way.
My spreadsheet showed that on certain credit spreads I could return 40% net (after winners and losers). It was with this information started the thread to see if I could smooth returns by hedging a portfolio full of these spreads. When PM stated I would not be cash-secured but margined, I took another look at the numbers and wondered why he would jump to such a conclusion.
My 40% return was based on what my broker charges in margin for a credit spread - not on the entire cash-secured amount. As soon as I divided my annual return by the cash secured return, I ended up with a return of less than 1%. (enter profanity here!)
So sure, I could make 40%, but only if I am fully leveraged, and as PM states, brokers will let you leverage these things10 times or more. That kind of leverage to make 40% is beyond my risk acceptance.
So in terms of Margin/Risk/Leverage/ whatever you want to call it, I am grateful PM posted his opinion. Sure, its pretty clear a 40/45 credit spread has a $500 max loss. But what does that really mean in terms of your potential reward over an entire portfolio?
Can I remind you that I am the OP, and that if you want to play in my sandbox, and get the nice toasted sandwiches and hotdogs, you have to place nice.
I am not sure if I completely understand both of you, and whilst I agree with both sides of the picture, I originally asked a question about hedging a portfolio full of credit spreads. Now I am not sure if PM's syntax is accurate, but to his credit, he certainly conveyed a message to me that allowed me to reasses my plan and see a potential risk I never knew I would need to accept.
My plan was only trade cash-secured credit spreads, and whilst PM did not highlight anything new in terms of risk - what he did highlight is that you can't really trade only credit spreads (verticals) and make any reasonable return without leveraging your equity in some way.
My spreadsheet showed that on certain credit spreads I could return 40% net (after winners and losers). It was with this information started the thread to see if I could smooth returns by hedging a portfolio full of these spreads. When PM stated I would not be cash-secured but margined, I took another look at the numbers and wondered why he would jump to such a conclusion.
My 40% return was based on what my broker charges in margin for a credit spread - not on the entire cash-secured amount. As soon as I divided my annual return by the cash secured return, I ended up with a return of less than 1%. (enter profanity here!)
So sure, I could make 40%, but only if I am fully leveraged, and as PM states, brokers will let you leverage these things10 times or more. That kind of leverage to make 40% is beyond my risk acceptance.
So in terms of Margin/Risk/Leverage/ whatever you want to call it, I am grateful PM posted his opinion. Sure, its pretty clear a 40/45 credit spread has a $500 max loss. But what does that really mean in terms of your potential reward over an entire portfolio?
<<<... I originally asked a question about hedging a portfolio full of credit spreads. Now I am not sure if PM's syntax is accurate, but to his credit, he certainly conveyed a message to me that allowed me to reasses my plan and see a potential risk I never knew I would need to accept.
My plan was only trade cash-secured credit spreads, and whilst PM did not highlight anything new in terms of risk - what he did highlight is that you can't really trade only credit spreads (verticals) and make any reasonable return without leveraging your equity in some way.... >>>
You just perfectly summed up the point I was hoping to convey, in my own rather long winded way.
Too many spread traders don't realize the massive amount of margin they are potentially using.
And as a result of that massive leverage, buying 95% of their stocks in a spread portfolio is impossible.
Hence, they are forced to close all their deteriorating positions for a potential loss. Even if their positions are only a tiny percentage ITM.... or even just a penny under both strikes. (a penny under both = max loss.)
Waiting for recovery due to a temporary bad market is simply NOT an option (choice).
Hence my message that spreads should only be used for the occasional trade where the sector or stock is particularly volatile, earnings or sig news are pending within the life of the contract, or there is no tech support anywhere near the stock.
Too risky to use spreads as an overall strategy for ones portfolios cash.
They are NOT as safe as reading their definition might imply.
A sudden and severe market drop can easily wipe out the entire account of a credit spread trader.... with no opportunity for recovery after the contract expires.
My plan was only trade cash-secured credit spreads, and whilst PM did not highlight anything new in terms of risk - what he did highlight is that you can't really trade only credit spreads (verticals) and make any reasonable return without leveraging your equity in some way.... >>>
You just perfectly summed up the point I was hoping to convey, in my own rather long winded way.
Too many spread traders don't realize the massive amount of margin they are potentially using.
And as a result of that massive leverage, buying 95% of their stocks in a spread portfolio is impossible.
Hence, they are forced to close all their deteriorating positions for a potential loss. Even if their positions are only a tiny percentage ITM.... or even just a penny under both strikes. (a penny under both = max loss.)
Waiting for recovery due to a temporary bad market is simply NOT an option (choice).
Hence my message that spreads should only be used for the occasional trade where the sector or stock is particularly volatile, earnings or sig news are pending within the life of the contract, or there is no tech support anywhere near the stock.
Too risky to use spreads as an overall strategy for ones portfolios cash.
They are NOT as safe as reading their definition might imply.
A sudden and severe market drop can easily wipe out the entire account of a credit spread trader.... with no opportunity for recovery after the contract expires.
I guess i need to say something since I am the credit spread guy around here.... more or less.
I actually agree with 99% of what PM says except perhaps for the missionary zeal with which he says it.
(BTW he USED to have a much MORE extreme position about credit spreads but I think we beat it out of him)
Particularly:
1. It is a really BAD plan to allocate your whole portfolio to credit spreads. Even I don't do that... not nearly.
2. Do mix bearish and bullish credit spreads within the set of spreads you have (e.g. I have a bear call spread about to expire on BBY... a real loser company)
3. I use primarily severely OTM credit spreads computed to give me about a 15% annualized return and having above 90% probability of expiring worthless (based on previous price distribution). I almost never do ATM spreads.
4. I utilize 'recession resistant' stocks as much as possible.
e.g. ABT, CWT
http://finance.yahoo.com/q/bc?t=5y&s=ABT&l=on&z=l&q=l&c=&ql=1&c=^GSPC
http://finance.yahoo.com/q/bc?t=5y&l=on&z=l&q=l&p=&a=&c=^GSPC&s=CWT&ql=1
I maintain a list of stocks that either buck the market (e.g. TLT) or are resistant to being sucked down into the abyss should 2008/2009 recur. There are currently 30 stocks on that list.
5. when in doubt get out. FAST. Don't dilly, don't dally don't let yourself be sucked into 'adjustments' to try to save a position.
e.g. I had a 35/30 Bull put spread on DG when the dollar stores topped out recently.
http://stockcharts.com/h-sc/ui?s=DG
I bailed as soon as DG dropped below support at 46. It had violated my trade hypothesis. I lost $40 on the trade. Better to lose $40 than $400 or $4000 and get involved in 'rescue trades'. I never do rescue trades.
It is better to suffer the early loss and move on to other safer, more lucrative trades. There's always someplace better to be.
I think that's all I have to say.
I actually agree with 99% of what PM says except perhaps for the missionary zeal with which he says it.
(BTW he USED to have a much MORE extreme position about credit spreads but I think we beat it out of him)
Particularly:
1. It is a really BAD plan to allocate your whole portfolio to credit spreads. Even I don't do that... not nearly.
2. Do mix bearish and bullish credit spreads within the set of spreads you have (e.g. I have a bear call spread about to expire on BBY... a real loser company)
3. I use primarily severely OTM credit spreads computed to give me about a 15% annualized return and having above 90% probability of expiring worthless (based on previous price distribution). I almost never do ATM spreads.
4. I utilize 'recession resistant' stocks as much as possible.
e.g. ABT, CWT
http://finance.yahoo.com/q/bc?t=5y&s=ABT&l=on&z=l&q=l&c=&ql=1&c=^GSPC
http://finance.yahoo.com/q/bc?t=5y&l=on&z=l&q=l&p=&a=&c=^GSPC&s=CWT&ql=1
I maintain a list of stocks that either buck the market (e.g. TLT) or are resistant to being sucked down into the abyss should 2008/2009 recur. There are currently 30 stocks on that list.
5. when in doubt get out. FAST. Don't dilly, don't dally don't let yourself be sucked into 'adjustments' to try to save a position.
e.g. I had a 35/30 Bull put spread on DG when the dollar stores topped out recently.
http://stockcharts.com/h-sc/ui?s=DG
I bailed as soon as DG dropped below support at 46. It had violated my trade hypothesis. I lost $40 on the trade. Better to lose $40 than $400 or $4000 and get involved in 'rescue trades'. I never do rescue trades.
It is better to suffer the early loss and move on to other safer, more lucrative trades. There's always someplace better to be.
I think that's all I have to say.
This is similar to what I do with my credit spreads... Far OTM (Delta of 5 or less on the short side..... I do not use stocks at all... just a few indexes (RUT, SPX & NDX).... I do not want earnings or news stories to significantly impact ny positions.
Yes, I prefer they expire worthless and target about 18-20% annually.
As PM mentions, I have closed out a few at a loss, but this is me plating it safe.... PM may not like tht word.
Nothing wrong with closing down a position for a loss.
I've done it myself.
I just don't like it when that is my only "choice", to manage a deteriorating position.
Absolutely agree..... "repair" in my mine is:
Closing the trade
Moving forther OTM if the market is moving against me
Have not practiced moving farther out (time).
These are all to avoid loss.... I execute these options while I am still far OTM (delta of 12-16).... Never want to get to an ATM situation.
About 90% successful and on track for me target of -18-20% annually