Profit Targets

When carrying a spread into expiration week that is either safely OTM (in the case of a credit spread) or ITM (a debit spread), the natural impulse is to allow it to expire for maximum profit. But let’s talk about that logic for a minute. It seems to make sense if the spread is so far away from the money that it feels “safe” that you might as well leave it on. After all, allowing a credit spread to expire saves a set of commissions (debit spreads are still on the hook for an exercise fee and commissions to simultaneously buy and sell the underlying). However, we can clearly see in the OTM graph that expiration week offers very little additional profit.

Let’s talk about this in terms of risk: You’ve sold a credit spread for $1 against $9 of margin. Going into expiration week, you are profitable, with the spread worth only 20 cents. In this case, you have already made 80% of the potential profit. By continuing with the trade you risk losing 80 cents in profits in addition to the $9 of original margin. What this means is you are risking $9.80 for a 20 cents in additional profit. If this was a new trade that you were considering putting on, would you risk $9.80 for a $0.20 profit, even if the spread felt “safe?” I know I wouldn’t. The reward does not support the risk. So in my mind, it makes sense to collect profits and move on to another trade.

This kind of scenario doesn’t always happen during expiration week. A strong directional move might see the same spread drop to 20 cents within a week or a few days. If you initiate a trade 40 days to expiration and at 30 days, you’ve made 80% of your max profit, does it really make sense to tie up your capital and risk the profit over the next month for an extra 20 cents? It doesn’t. So with vertical spreads, I always create a profit target.

The most commonly used profit target is 80% of the maximum potential profit. Almost everyone that I know uses this target and for a long time, so did I. I’m now using 70% for most trades and I’ll tell you why: Let’s say you want to buy back a $1 spread for 20 cents. To fill your order, someone must be out there willing to take the other side of your position. You need a market maker that is willing to sell a credit spread for 20 cents. If I won’t risk $9.80 to make 20 cents, do you think a market maker would? No way! To be fair, I can’t pretend to know what floor traders do and there are exceptions when they will actually take the order. But for the most part, it is very difficult to get out of a credit spread that is very low in price. At most 80% profit targets, an order will not fill. You may be trying to buy back a spread for 20 cents that is listed at 15 cents and go for days without getting filled. In my experience at 80%, I’ve either had to leg out with single leg option orders or cave in on price so much that when all is said and done, my final profit is only 70% of my potential profit – a profit point that many times, I’d already been sitting at for a week or more. So now I simply look to make 70% of my max profit.

Execution at 70% is easily done at the spread’s mid price, without the need leg out. So instead of waiting for 80% profit and ending up with 70%, I just take the 70% up front and get out of the trades earlier. All that being said, some of the more liquid vehicles can sometimes be executed without too much hassle at 80% of max profit.

The Stop Loss

The 20% stop loss is the most popular form of management that I see the apprentices trading. I’ve debated this strategy with myself for awhile, questioning its long term business sense. The piece that bothers me is that if you are taking 20% losses against average profits of 10%, you have to win 2 out of 3 trades just to break-even. In the short term, this can create losing streaks. However, if positioning your short strike at one standard deviation, you theoretically have an 82% probability of profit – which means in the long term you will win 4 out of every 5 trades. This doesn’t count the added probability of trading validated directional signals. So if looking for an easy, hands-off strategy, the 20% stop loss is made for you.

Adjustments:

The Point of Adjusting:

To reposition the spread on the distribution curve. If you remember the Normal Distribution Curve I introduced in The Vertical Spread Semi-Directional System . we initiate the trade at one standard deviation. If price moves against us, we were incorrect about our assessment of volatility and/or the direction of price movement. In this case, we need to admit to being wrong and reposition the spread. To widen the expiration break-even. To flatten deltas.

I use a 20% stop loss as a worst case scenario in conjunction with an adjustment strategy. I’ve seen traders (myself included) adjust positions so heavily that they’ve reduced potential profits to a point that the trade is not worth continuing, even if only at a minimal loss. While not true of every adjustment, most of the techniques that I’ll talk about here reduce profit potential and add capital, damaging the original risk/ reward ratio. I think you’ll agree that a trade that begins risking $9 for $1, but thru various adjustments ends up risking $9.90 for 10 cents is not a good trade. At that point, it is time to move on to the next trade. This can happen when adjusting too soon, too late or too often. Due to the limited profit potential of a vertical spread, adjustments are commission intensive and sometimes very difficult, but a smart adjustment plan can correct miscalculated entries and turn losing trades into winners.

In my experience, the optimal adjustment point is at about a 10% loss. If placing spreads one standard deviation from price, the easiest way to calculate this when the spread price is greater than 2x the initial credit (or max profit, in the case of a debit spread). For example: if I receive $1 credit against $9 margin in a credit spread, then I will adjust when the spread equals $2. In a debit spread, if I pay $9 for a max profit of $1, then I’ll adjust when the spread drops to $8. These are just rule of thumb calculations that position the adjustment at more or less 10%. On more aggressively placed spreads, this simple math doesn’t work. A spread with a max profit of 18% for instance, will be sitting at an 18% loss before adjusting if using the 2x initial credit calculation. In those cases I adjust sooner, around 10 or 11% loss of margin.

Adjustment #1: Repositioning the spread with a Vertical Roll

In the Vertical Roll, you take off the original position and re-sell (or buy) it another standard deviation away from price. Depending on the price of the stock, this usually means just rolling the spread away from price by one strike. When you roll, you need to increase the size of the position enough to maintain the same initial max profit.

A word of warning – in Vegas, they call this a Martingale. You are adding risk—many times doubling your margin while price is moving against your position, for the same dollar-amount return (and half the % return). Hedge funds with seemingly unlimited capital can roll a countless number of times. You and I can’t. My guideline is that I will only roll one time and only if I can get the same profit without more than doubling the number of contracts. In this case, a position that started at $9 of margin for a $1 return is now at $19 of margin for $1 return. Note that while this adjustment keeps your max profit dollar amount the same, it reduces your percentage return by about half. This makes it very difficult to additionally adjust without completely changing the semi-directional character of the trade.

If this is a strategy you intend to use (it is one that I use about 50% of the time), you may consider sizing your original position at half your normal size. I size my vertical spreads at roughly 5 to 7% of my portfolio so that a roll will not increase my position size to more than 10 to 14% of my portfolio. Using a 20% max loss on each position keeps the portfolio risk to 2 to 3%.

Adjustment #2: The Long Put or Call

When price is moving particularly fast, buying a long call or put is a far better adjustment than rolling. This is especially true of puts when price is breaking down against a bull spread. We all know that price can make violent moves to the downside and that markets rarely “crash” upwards. The option market’s immediate reaction to fast downside movement is an increase in implied volatility, most pronounced in the short term options. Buying front month puts can take advantage of this rise in volatility. The front month will increase in value at a far faster rate than the next month out because they are larger in gamma (meaning they will grow in delta at a faster rate than the next month) and they are more responsive to short term volatility fluctuations. I tend to buy puts in the front month as protection against these strong moves up to about 15 days to expiration. At that point, time decay becomes too strong and the next month becomes a better trade.

The put is only a temporary Band-Aid. You are hoping to flatten the delta of your overall position so that if price continues going south, you are not taking continued losses. The screen shot below shows a Bull Spread in blue and the spread with the added put in red.

Notice how the red dotted line is flattened to protect the position. In uncertain times, I will sometimes buy enough put protection to make this line—called the T+0 line (Trade + 0 days)—completely flat. What is happening is the negative deltas of the puts are offsetting the positive deltas of the Bull Spread and neutralizing the position’s price risk (flattening deltas).

I’m sure you will notice that the max profit of the vertical has been seriously damaged by the cost of the put. In the example above, the extra put took the potential profit from about 2K to about $700. This is not the end of the world. The purpose of the put is not to profit from a downside move, but to provide protection for the Bull Spread. In fact, if the put is profitable, the overall position will need further adjusting (like a roll) or may even be a loss.

Buying puts is temporary protection and the time to do it is when price is moving too quickly to roll and/ or when you believe the price movement is temporary. Ideally, price will recover and you will sell the put at a slight loss, popping the potential profit of the spread back near the original amount. Honestly, this can be difficult to manage. It can be very frustrating to sell back a put at a heavy loss, and find the resulting position with uncomfortably large risk compared to the remaining reward.

For this reason, I rarely buy calls. In fact, I can’t think of a time in the recent past when I’ve bought calls against a directionally placed vertical spread. But it is a completely viable thing to do if price is breaking upwards. With calls though, the benefit of trading the front month is not there. Usually when price is heading up, it does so in a measured way and the market is considered “stable.” Implied volatility is therefore shrinking. Everyone has heard the idiom, “Bulls climb the stairs and Bears fall out windows.” When price is dropping, the market is less stable and the probability of big moves in the short term is larger—hence, the rise in volatility and the benefit of trading front month puts. When prices drop quickly, hedge fund managers begin buying up lots of puts as portfolio protection. With demand up, the price of the puts rise. Call prices must also rise with the puts to prevent arbitrage opportunities, so the implied volatility of calls rises as well. This is a long way of saying that when prices are dropping, short term puts are beneficial, but when prices are rising, I always buy calls with at least 30 days to expiration.

Adjustment #3: The Vertical Spread

If you only use the first two strategies, you will be doing what I do 99% of the time. But there are a few other adjustment strategies out there that I’ve used that do not change the character of the trade to a completely neutral position. For those of you new to trading spreads, I’d avoid these adjustments as the complexity of them might outstrip their particular benefits. I’m tempted not to include them, because they open a can of worms for discussing theoretic price modeling and I’ve seen too many traders have their attention drawn away from the main point of trading (profit!) by academic discourse.

The first is buying an OTM Debit Spread (or in ITM Credit Spread) against your original position as shown in the risk graph below.

If price is moving against your position in a measured way, the vertical spread is cheaper than buying a long and it does not result in as much a loss to max profit if price recovers. In the example above, I am long a 450/ 460 Bull Spread. When price dropped, I bought a 460/ 470 Bear Spread. The strike prices do not always line up like this, but in this particular example some of you might recognize the resulting risk graph as a Broken Wing Butterfly. With this adjustment, the expiration break-even is widened and the deltas of the position flattened, as reflected in the pink T+0 line.

Adjustment #4: The Calendar Spread

On a Bull Spread, the calendar can be used if price drops too close for comfort to your short strike. In the example below, I have sold the front month 480 Puts and bought the next month’s 480 Puts. The identical position can be constructed with the 480 Calls. This adjustment makes sense when price is hovering stubbornly near your Bull Spread’s short strike. When that happens, the short strike becomes vulnerable to volatility fluctuations. The Calendar spread props up the max profit in this area, gives your spread larger theta and widens the expiration break-evens. The calendar adds a third dimension to the trade as well: if volatility should rise across both the front and back months at about the same rate, the calendar spread will gain value. This theoretically protects the short strike of the vertical spread from volatility fluctuations because of its close proximity to price. I say theoretically because volatility does not always rise evenly across the front and back months.

Adjustment #5: The Butterfly Spread

Similar to using the Calendar Spread as a downside adjustment, the Butterfly (or Iron Butterfly) can be used as an upside adjustment when price is either making a slow rise or is consolidating near the short strike. While the Calendar spread benefits from rising volatility, the Butterfly benefits from declining volatility. If price ends up fall back down, you can buy back only the Bull side of the butterfly and leave the bear side in place.