Quote from Cache Landing:
... would anyone like to expound apon why they think that this would work better with debit spreads (or visa versa)?
No arguements please. Just simple ideas and opinions.
Well I'm sad and pathetic enough to come here at this time to respond.
Basically, you've unwittingly (or perhaps not) stumbled upon the "great divisor" when it comes to option trading practitioners here on ET. At least based on my observations.
Assuming you know that for every credit spread there is a synthetically equivalent debit spread related to each other by a fairly constant known as a box then I will restrict discussion to differences in approach (moneyness) to credit spreading only as any given credit spread arguably has some cashflow benefits over the equivalent debit spread (again this is up for debate and matter of circumstance)
In the blue corner we have:
High probability/high risk/low reward credit spread traders who don't mind taking on large gamma exposure by selling FOTM credit spreads with high probabilities.
Some refer to this as selling "cheap gamma" (which is leveraged in the wrong direction) and believe that this approach is just asking for trouble in the long term i.e. it's all fun and games until it's not.
Others believe that if you have a good risk management approach you can overt disaster from ever happening.
In the red corner we have:
Low risk/high reward ATM credit spreading or arb equivalent butterflies where the gamma characteristics are much friendlier at the expense of lower probability of success.
In Riskarb's terminology: an ATM butterfly is long upside gamma or convexity (the wings) and short downside gamma (the body)
The thing to bear in mind is that although your probability of success goes up the further OTM you are, your reward appears to go down at a FASTER rate than the gamma exposure goes up. So from that point of view, the best risk/reward really is ATM and it just gets worse from there. Despite knowing that, some traders prefer giving the underlying a wide berth and take comfort in high probabilities.
The key point to take away, if I'm not being too patronizing ,is the "short downside gamma" part which contrasts with the offending "short upside gamma" you have in a FOTM credit spread i.e. when your ATM, gamma has nowhere to go but DOWN - this is a good thing from an exposure point of view. When you're FOTM, gamma can only go UP as the underlying approaches and your FOTM becomes ATM. I'm sure I could have explained that better but the jist is there for those that care.
So, as for your quesiton on whether this would work better with debit spreads vs credit spreads, I think you can agree that the credit/debit point is moot.
The
real question is whether this would work better ITM,ATM,OTM or FOTM whereby an ITM credit spread is synthetically the same as an OTM debit spread and so on etc.
As stated above, there is the blue corner and the red corner, or you can just take a view on risk/reward and sit somewhere in the middle. If you are a good directional trader then none of this really makes a difference. If you can catch reversals reliably then you're bank.
Presumably you came up with your percentage allocations from what fits with your personal risk appetite and style. Perhaps that is what it really all boils down to. Personal preference.
Indeed, your percentage allocations is what piqued my interest as I'm curious to see the rationale and results from those choices.
If you know the risks and you know what you're getting for your risk...and you're happy even though you know it's not neccessarily the best deal for your money, then who's to tell you to do otherwise!
That should provide food for further expounding LOL.
Happy trading.
MoMoney.
