From the October 01, 2010 issue of Futures Magazine • Subscribe!

Credit spreads in a choppy, volatile market

Question: How can you maintain opportunity in a credit spread when one leg gets too close?

Answer: Purchase a long option as a hedge.

Credit spreads are a great strategy for taking advantage of choppy and volatile markets. They also allow traders to put on more size and avoid the risk of naked options. In previous articles, readers have been taught different strategies to deal with options volatility. Here, we will discuss what traders can do to maintain a position if a vertical credit spread begins to move against them and approach the strike price of the short leg. In a vertical credit spread, traders buy and sell puts or calls with different strikes of the same expiration month. Sometimes, the short option is close to the money and at other times it is out-of-the-money.

When the underlying approaches the strike of the short option, traders runs the risk of having the underlying either being put to them, and thus having to purchase it, or being called away, and thus short in the underlying. Basically, traders have the choice of either having the option exercised against them or closing out the short position. In the latter case, traders typically will have a price at which to exit the trade with a loss based on a certain stop on the underlying. There is a strategy that may be a more profitable approach to credit spreads. This involves purchasing a long option as a hedge against the vertical spread. This can be done in three ways.

The first approach is to purchase an in-the-money option with the same month expiration as those of the spread and one-half as many contracts as are in each leg of the spread, so that effective delta of the selected hedging option equals approximately 1.3 times the net delta of the spread. This hedging option can be triggered by a contingent order around the same underlying price as the stop loss on the vertical spread position. Once the underlying reaches support or resistance, the trader can take profit on the hedge option position and keep the credit spread, which could expire worthless at expiration and leave the trader with the premium. Thus the trader makes profits off the credit spread and the hedge. Or, the trader can exit the credit spread, essentially being flat while taking the profit from the hedge position into consideration.

The second approach is to purchase an in-the-money option with the same expiration as the credit spread and a delta equal to two to three times the net delta of the position. In this case, the hedge is initiated at the same time as in the previous approach, but the trader plans to make a profit on the hedge and decides whether to unwind the spread or keep it until expiration if the spread reverses back towards the initial target. This approach lends itself to day trades around the initial spread position, particularly if the trader employs an even higher delta. In both approaches, the trader can buy back the short option and create a vertical credit spread, particularly if the spread has sufficient time value and the underlying is reversing in the opposite direction of the initial credit spread.

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The third approach is to buy an option as a hedge that is farther out in the expiration month and deeper in the money to make profit during pullbacks. It also provides the trader an opportunity to capitalize on market and security reversals that occur during a vertical credit spread.

ImageWe modeled the second approach using the Apple (AAPL) October 240/230 put credit spread with the October 250 put as the hedge option. “Improving your odds” (above) shows the profit and loss curve at the expiration of the credit spread (first chart). The second chart shows the P/L of the credit spread with the hedge position 12 days into the trade. The net delta of the spread is approximately 0.10 and the hedge 0.30. The green line represents the approximate P/L two weeks into the trade. The specific strike selected depends on the spreads between consecutive strikes in the option chain. With time, traders can calibrate their hedges to produce the best results.

Frank Stanley, Ph.D. is a licensed clinical psychologist. He teaches options courses for DTI and has taught and mentored on the psychology of trading for many years. For more on DTI, vist their Web site at dtitrader.com.

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