Vol:
Couple of points:
1. In post 9/11 market went from 9/10 close to 9/17 low of about 5.3%. In absolute numbers it was a 50 point drop. It did not gap open to the 5.3% drop but certainly fell fast nonetheless.
2. Just because the market drops does not mean the spread moves to the maximum value of loss immediately. So a drop in the market does not translate to a $500K loss. To use an example that would make MAV happy, assume you have a deep OTM $50/$55 bull call spread when the stock is at $20 and the stock jumps $35 points. The spread will not be worth $5.00.
3. The futures market is the best place to hedge against these kind of events. If the market is crashing because of a major event, I can short futures immediately to put bandages on and get out of my positions if necessary.
4. Although the validity of this has not been fully tested and was debated here, I am loaded up on VIX Calls for MAY assuming a huge drop in the index will accompany a VIX spike which could push those options significantly higher acting as a hedge (if it all goes according to plan
)
5. I am hedged even before I get into any position by not putting 100% of my assets in any one position. So I will never be wiped out or taken off in a stretcher.
6. If the market drops and I have to take a loss to get out, I am fully prepared to do so. I will also trade the heck out of the market on the way down to mitigate my losses (I daytrade Es futures as well so I would short them like crazy in a fall until I can get out of everything cleanly with as little damage as possible- taking a loss is not the issue, doing what I can to mitigate it is my goal). But the Point is really that if the US is being blown up and the market crashed, I can only limit my losses and get out.
People always aks me how to hedge the position and I always have to tell them that there is no way to perfectly hedge this posiiton because it is not a risk-free trade. For normal market months I use my experience and skill in selecting strikes and for potential abnormal moves I put on partial hedges where I can or have the futures market if needed and accessible. Right now I am using VIX options for adverse down movements as a potential hedge.
There are also position adjustments where I can roll into a Prego FLy (skip strike butterfly) and create a position with a limited risk debit much much lower than the credit spread risk and potential for more profits if the market stays down. I could also adjust if the move takes the market to my doorstep but there is little time to expiration and I just need some distance. I could box the position and open new spreads at lower strikes and keep reducing my net loss little by little until I hit expiration.
The goal is to stay on top of the position and keep reducing losses as best you can to get out and trade the next month. The thing about such a drop is that with IV spiked, you can get some good premium the next few months and with SPX put skews go deeper OTM and collect premium. Post 9/11, July 2002 and even 1987 drops were all followed by consolidation and strong reversals. The key is to stay on top of your positions and trade past the loss. You will not make it back immediately but thinking long-term you can do it. Portfolio management is what ensures you are not wiped out and still have capital to trade with after such moves.
Quote from Vol:
Optioncoach:
I have a question about risk and how you manage it.
You posted on April 13 your position on 500 SPX 1215/1225 bull credit spread. SPX closed at 1289 on that day.
Then significant event occurs. S&P only has to drop 5.7% for your position to be negative almost 0.5M.
How is this risk managed?
