by Linda Piazza

HAVING TROUBLE PRINTING?

The last three weekend Trader’s Corner articles have listed possible adjustment and exit strategies for high-probability credit spreads and iron condors. Those strategies were gleaned from my two years’ study of webinars, seminars, and written material. I’ve just ordered a new book on Options Strategies by James Bittman, veteran floor trader and a senior instructor with the educational arm of the CBOE, where I’m sure I’ll find a few more ideas.

I hope this series of articles encourages subscribers to keep honing their skills, too, learning from others with sound credentials as I’ve tried to do. Each strategy has pros and cons that subscribers should discuss with their brokers. My focus in my Trader’s Corner article is to represent the self-taught trader, so I’ve been inviting you along all these years as I explore and learn.

Some adjustments or hedges are cheap and some are expensive. As I mentioned last week when discussing a strategy that I have successfully utilized, my broker doesn’t like adjustments that cost more than the income brought in by the credit spread or iron condor. He views that as taking on additional risk. One adjustment that is expensive up front, certainly, is one suggested by Steven Gail in his Monthly Cash Machine tutorial. Gail’s suggestion is a possible credit spread adjustment that might be appropriate in a strongly trending market running up to a sold strike. That adjustment consists of buying to close the sold strike and letting the long option run.

Buying to close the sold strike without simultaneously selling to close the long strike will prove too expensive for many option traders to consider this strategy. For example, imagine that a trader had 10 contracts of a RUT JAN 500/510 bull call spread on December 31 and decided, near the close, to buy to close the sold JAN 500 calls, letting the long 510’s run. The midpoint of the bid/ask spread on that 500 call was $16.30, so let’s assume that the trader actually paid a little more, about $16.50. That’s a hefty $16,500 plus commissions to buy to close the 10 contracts of the sold 500 strike.

The danger here, of course, is that the trader who believes that a strong trend is in place, buying to close the sold strike, might experience an immediate reversal of the trend. Premium might pour out of the long, further out-of-the-money strike, premium that will no longer be available to hedge the cost of buying to close the 500 call. The trader who then scrambles to sell that long portion of the former spread will recoup much less money than would have been possible if the whole credit spread had been exited at once. In effect, this trader who tried legging out of a going-wrong credit spread ended up paying far more of a debit and incurred much more of a loss than if the spread had been closed all at once.

Yet, I have seen times when this tactic would have been effective. The first time I got caught in a significant number of contracts of an iron condor going wrong was with a CME iron condor three or four years ago. Some of you may also have reason to remember that trade. CME charged up right through both strikes of the bear call spread portion of iron condor and kept on going. If I had bought to close the sold strike and let the other one run, I would have recouped all the losses from buying to close the sold strike. And then some.

Even though I watched an instance when that tactic would have worked, I still have not been tempted to use it because of the expense and risk. However, I wanted to mention it since I have seen it work and since Gail, an experienced trader, suggests it as a possibility. Clearly it has worked and can work, but it doesn’t fit my more conservative style.

Some experienced and aggressive traders might feel that using technical analysis or other tools can help a trader gauge when this might be a good tactic to try, but I’m sticking with the other strategies I’ve tried for now. Traders tempted to use this tactic should realize that, for high-probability iron condors and credit spreads, the very fact that prices have run up or down to a sold strike means that an unusual event has occurred, and markets might not be behaving in any typical manner. Price exhaustion might quickly occur or prices could barrel right through further support or resistance levels, and it may be difficult to discern which will happen from standard technical analysis tools. Those standard technical analysis tools have already failed to predict that a sold strike will be hit, or the trade wouldn’t have been entered in the first place.

Some traders may find their accounts benefit from just adopting a delta-based decision point and then always stepping out of contracts as that point is reached. Legging out of the spread, whether a stand-alone one or part of an iron condor, is probably best left to more experienced and aggressive traders.

What are other suggestions for adjustments? A few of the sold strikes could be bought back, leaving more long than short strikes. Depending on the time until expiration, a few extra of the long strikes could be bought. Sheridan suggests this last tactic both as a partial hedge for a credit spread that is edging toward trouble and as a tactic to be considered when first entering the trade.

Another hedging tactic my broker has suggested and that I have tried is putting debit spreads in front of or straddling my credit spreads. The benefit of this tactic is that, since it’s a spread, it might not be as expensive as some other adjustments, depending on where the debit spread is placed. The risk is that prices never approach the debit spread and the premium spent for establishing this spread is lost.

For those unfamiliar with a debit spread, this type of spread is entered by buying a call or put and then selling one further out of the money. Since the trader is buying the more expensive option and selling the further out-of-the-money one, a debit is paid; hence, the name. This type of spread has a limited profit and limited loss, and gains when prices move through the long option and toward the sold option. Thus, if a trader had put a debit spread in front of a credit spread, the debit spread would be gaining as prices approached the credit spread’s sold strike.

My broker suggested this tactic when I was worried about a credit spread one afternoon and was considering the pro-active tactic of exiting a few of my credit spreads to lessen risk. He suggested this method of lowering the risk, saying it would cost only a few cents more than the debit I would pay to exit the credit spread that was worrying me. If prices did draw closer to my credit spread, the hedging debit spread would be gaining money. The credit spread had been on the SPX, and I had been able to straddle the sold strike of my credit spread with the debit spread’s strikes. That’s not so easy with the RUT with its 10-point spreads, of course.

For example, let’s go back to last week’s example of a hypothetical RUT JAN 430/420 bull put spread in a trader’s account on December 18, 2008. The delta of the 430 put would have been -0.2171, or -21.71 with the 100 multiple, that day. A worried trader could have bought a bear put spread, a debit spread, as a hedge. This debit spread would gain as the RUT moved down and through the sold strike, offsetting losses in the bull put credit spread. But what debit spread could have been bought?

The 10-point spreads between strikes would not allow a bear put spread to straddle that hypothetical RUT bull put spread we’ve used in the example. In other words, no RUT JAN 425/435 bear put spread would have been available. Nor could the 440/430 bear put spread, a debit spread, have been bought without changing the nature of the trade. The short 430’s in that hedging debit spread would have added to the number of short 430’s in the credit spread, turning the trade into a butterfly. The trader would have had to go higher with the debit spread unless the intention was to set up a butterfly.

In general, most brokers who have suggested this method of putting a debit spread in front of a credit spread advise putting on only about 1/3 to 1/2 as many hedging debit spreads as there are credit spreads. This partially offsets any potential losses without costing inordinate amounts to put on the hedge.

I have not used debit spreads to hedge a credit spread that was already venturing into dangerous territory, but I did use this tactic when the credit spread was not yet in trouble but the technical setup was worrisome. In this case, the cost of a few hedging debit spreads truly was only a few cents more than closing out the same number of credit spreads because the sold strikes weren’t being closely approached. When the underlying did creep closer to my sold strike, those debit spreads were already established, allowing me to watch the action for a time, making appropriate decisions, while knowing that my credit spreads were at least partially hedged.

Similarly, Sheridan, Lusk and many others suggest establishing out-of-the-money cheap butterflies at the sold strikes of credit spreads to hedge. These far out-of-the-money butterflies generally are cheap and are one of the methods my broker has suggested hedging a credit spread.

A butterfly is an all-call or all-put position in which the body consists of a number of sold strikes and the wings, of long hedging strikes either side of the body, at equal distances. Twice as many strikes are sold at the body as are bought at either wing. If the underlying moves against the position and settles near the sold strike, the butterfly will be profitable.

I am not going to discuss this possibility in any depth because my experience with butterflies has not been a happy one. I have done some cheap speculative butterflies in which the underlying settled on the sold strike for an hour or more on the last day before option expiration and the trades were still only breakeven and not profitable. Either my brokerage charges too much for the commission-intensive trades to make profit possible, I don’t get optimum prices when placing them, or they just don’t work the way I expect them to work. Something obviously doesn’t work right for me with butterflies, but I continue to encounter many experienced traders who suggest them as hedges or adjustments for credit spreads. Somebody somewhere finds them helpful. I mention this tactic to prod you into doing your own research or trying them on simulators. They’re just not the right hedge or adjustment method for me at this time.

These are some of the hedging or adjustment suggestions I’ve encountered when I began looking for alternatives to the let-them-run or else take-a-big-loss-when-the-sold-strike-is-hit mentality. Years ago, when I first began moving up in the number of contracts I traded, I took a loss in the realm of $30,000, and that wasn’t anything I ever wanted to do again. Sheridan says that losses should be no more than 1 to 1.5 times (and, sometimes, in some webinars, 2 times) your average gain over a six-month period, and that’s what I’ve aimed to do, using some of these methods discussed over the last few weeks. I don’t know of any method that’s going to guarantee that you won’t suffer a loss, and if there were, we’d all be trading high-probability condors with abandon, safe from any worries. Each strategy has pros and cons. Some are appropriate for conservative traders; some, only for aggressive traders.

With high-profitability credit spreads and condors, a trader expects 85-95 percent of the trades to be profitable. A loss of 1 to 2 times the average gain, experienced only with 10-15 percent of the trades, means that traders keep making profits over the long run. A loss that takes six months to make up? Well, you add it up for yourself.