Vertical spreads, notional value, and risk management

J

jimmyjazz

I am exploring the use of vertical spreads to make directional trades on stocks. I like their quantified risk/reward profile. Assume for the moment that my "risk management" will be limited to closing out the spread either the day before expiry or (perhaps) earlier if the underlying or spread value hit a certain price. (Note that I am not a fan of stop losses, but I need to remain open to any differences between trading spreads and trading the underlying.)

In reading through what has felt like every thread on ET, I see considerable concern about the short leg of a vertical CREDIT spread (bull put, bear call) going ITM. Questions:

1. Why should I be more concerned about an ITM put in a credit spread than an ITM put in a debit spread?

2. Why should I be more concerned about an ITM call in a credit spread than an ITM call in a debit spread?

3. Why are these concerns seemingly voiced most often about spreads that are trading between the strikes as opposed to those which have gone ITM on both legs? Is it because of the way (most?) brokers handle assignment; i.e., if both legs are ITM they will just do a same-day transaction to close out the spread for the net loss when assigned, or is it more subtle than that?

Thanks in advance for any help!
 
Quote from jimmyjazz:


In reading through what has felt like every thread on ET, I see considerable concern about the short leg of a vertical CREDIT spread (bull put, bear call) going ITM. Questions:

1. Why should I be more concerned about an ITM put in a credit spread than an ITM put in a debit spread?

2. Why should I be more concerned about an ITM call in a credit spread than an ITM call in a debit spread?

Thanks in advance for any help!
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If you're worried about early assignment on the ITM leg, not properly assigning on the long leg in a debit spread is just as much a risk as getting assigned on a short leg of a credit spread.

That aside, the reason you'd be more worried about being ITM on a put in a credit spread vs. a debit spread is that you're losing money in one and making money in the other.:D

Is there a particular thread/post you had in mind?
 
Thanks. I'm not sure I follow your answer, so let me clarify:

I am OK with the trade going south; i.e., failing to correctly call direction. The winning trades in my system more than offset the losing trades when I stick to trading the underlying. (I know, I know. "Stick to trading the underlying." I am trying to put more arrows in my quiver.)

I guess what I'm worried about is the notional value of the short legs of spreads. I don't understand why this seems to be more of a concern with spreads that were put on for a credit. (See many of Put_Master's posts.) If I am short an ITM option, I have real risk, right? Regardless of the condition of other legs of that trade or even my portfolio in general?
 
Yea, if your short leg is ITM on a debit spread, that's good, if it's ITM on a credit spread, that's bad.

To your point, yes, if your short leg on a credit spread is ITM, that's a real risk, more so if the notional is larger than you can afford to get assigned on. But that's also true for a debit spread, it's just less concerning because you can just close it for a profit instead of a loss.

IIRC the Put_Master threads were about spreads vs. naked. I'll just leave it that it's a personal preference and they offer different risk/reward characteristics.
 
Quote from Soon2Bgreat:

To your point, yes, if your short leg on a credit spread is ITM, that's a real risk, more so if the notional is larger than you can afford to get assigned on.
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Can you articulate the reason the short leg being ITM is more of a risk on a credit spread than a debit spread? Either can be assigned. I'm trying to understand exactly how these situations play out in the real world. Is assignment in a debit spread less onerous simply because of the way a broker will net out the trade when assignment occurs?

Obviously, if the underlying is between the strikes on a credit spread and assignment occurs, I will have to either buy or sell the underlying at the notional value. The OTM leg does me no good. Should I not be worried about notional value when both legs are ITM?
 
Quote from jimmyjazz:

Can you articulate the reason the short leg being ITM is more of a risk on a credit spread than a debit spread? Either can be assigned. I'm trying to understand exactly how these situations play out in the real world. Is assignment in a debit spread less onerous simply because of the way a broker will net out the trade when assignment occurs?

Obviously, if the underlying is between the strikes on a credit spread and assignment occurs, I will have to either buy or sell the underlying at the notional value. The OTM leg does me no good. Should I not be worried about notional value when both legs are ITM?
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On a debit spread, you are hoping for the trade to go towards the OTM short leg. That means it's profitable.

On a credit spread you want the opposite. For the trade to be profitable it should travel, or stay away, from your short leg.

Sell a put, hoping underlying goes long. (away from your strike)

Buy a put, hoping underlying goes short. ( to and past your strike)
 
I understand direction. I am asking for specific details on the manner in which a broker might handle the assignment of an ITM short leg. Is it a function of whether or not the other leg is ITM?
 
Here's some info on assignments, and your broker probably has some as well.: http://www.cboe.com/LearnCenter/Concepts/Beyond/expiration.aspx

To answer your question, no, assignment of each leg is determined individually.

Forget credit vs. debit and long vs. short for a minute. With options, there's always a risk of whether a position will finish itm or not and what a position may look like post expiration (the more legs the more potential complications). The easiest solution when presented with uncertainty is always to close the position before expiration. Trying to anticipate where the market will expire and how your position will look post expiration is more risky than just closing the position. HTH.
 
Understood. My question remains, would a broker typically force me to take delivery of shares on an ITM short put that is suddenly exercised EARLY if I also hold an ITM short put at a different strike? Or would a broker typically just net out the trade by simultaneously exercising my long put (with an additional cash transaction)?

Similar question on early exercise of short ITM calls.
 
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