Long time lurker, first time poster. Itâs clear a lot of the folks were scared away from credit spreads and iron condors due to the market volatility in recent years. Most notably, the meltdown during the last quarter of 2008 and the flash crash of May 2010. I see many folks are very critical of some of the credit spread trading journals because, as one quickly learns, one extreme market move can blow out credit spread traderâs profits and capital. Nevertheless this is such an enticing strategy because of its high probability of success.
Iâve done some back testing using a sort of credit spread hedge with the VIX that Iâm certain someone has thought about before. I wanted to share the idea and see if you someone can explain why it would not be a good plan.
The idea basically involves hedging your SPX credit spreads with a long VIX 40 call of the same expiration month using a 3:1 ratio (3 SPX credit spreads for each VIX call). Why 40? If you look at the historical meltdowns mentioned above that killed credit spread traders, in each case the VIX reached 40 or greater. Using TOS thinkback and your classic 9% - 10% profitibility bull put spread 45 - 60 days in advance one can normally get a VIX 40 call from anywhere between $17 to $40 on average. Using this criteria, I tested by selling 3 1140/1130 OCT 08 bull put credit spreads in late August 08 and 3 1020/1010 NOV 08 bull put credit spreads in late September 08 (both dooms day trades
). You see that each of these reach maximum loss. Now add the very cheap VIX 40 call and see what happens? The 2008 crash is now survivable to a credit spread trader. In fact, if your timing and stomach acid level was right, November reached a few profitable points. Do the same test by putting on a MAY 10 vertical spread in March 10 and the flash crash is profitable as well. If market fundamentals or stomach acid level dictate a period of volatility may be looming you could increase the ratio to 3:2 for even better protection. I understand the VIX is based off futures, but back testing seems to show that this could be a life saver.
The flip side to this is how much profit is lost when all is well? Clearly that will vary based off market conditions and the price of VIX calls, but under stable conditions it seems to me an affordable insurance policy netting only a 1.20% â 1.50% profit sacrifice for the insurance. For example a VIX 40 call for JUN 11 as of this writing is $35. If I put on 3 SPX 1230/1220 receiving a credit of $255.00 (risking $2745.00, 9.29% profit), the VIX 40 call for $35 buys me a comfortable hedge. Thatâs a 1.28% cut into the credit received.
Any thoughts?
Iâve done some back testing using a sort of credit spread hedge with the VIX that Iâm certain someone has thought about before. I wanted to share the idea and see if you someone can explain why it would not be a good plan.
The idea basically involves hedging your SPX credit spreads with a long VIX 40 call of the same expiration month using a 3:1 ratio (3 SPX credit spreads for each VIX call). Why 40? If you look at the historical meltdowns mentioned above that killed credit spread traders, in each case the VIX reached 40 or greater. Using TOS thinkback and your classic 9% - 10% profitibility bull put spread 45 - 60 days in advance one can normally get a VIX 40 call from anywhere between $17 to $40 on average. Using this criteria, I tested by selling 3 1140/1130 OCT 08 bull put credit spreads in late August 08 and 3 1020/1010 NOV 08 bull put credit spreads in late September 08 (both dooms day trades
). You see that each of these reach maximum loss. Now add the very cheap VIX 40 call and see what happens? The 2008 crash is now survivable to a credit spread trader. In fact, if your timing and stomach acid level was right, November reached a few profitable points. Do the same test by putting on a MAY 10 vertical spread in March 10 and the flash crash is profitable as well. If market fundamentals or stomach acid level dictate a period of volatility may be looming you could increase the ratio to 3:2 for even better protection. I understand the VIX is based off futures, but back testing seems to show that this could be a life saver. The flip side to this is how much profit is lost when all is well? Clearly that will vary based off market conditions and the price of VIX calls, but under stable conditions it seems to me an affordable insurance policy netting only a 1.20% â 1.50% profit sacrifice for the insurance. For example a VIX 40 call for JUN 11 as of this writing is $35. If I put on 3 SPX 1230/1220 receiving a credit of $255.00 (risking $2745.00, 9.29% profit), the VIX 40 call for $35 buys me a comfortable hedge. Thatâs a 1.28% cut into the credit received.
Any thoughts?
