Risk Management: When to Roll a Credit Spread

Adjusting a Credit Spread

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Repairman. © Pixabay

A reader asks how to repair a credit spread when the short option has moved into the money. This is the second part of that conversation. Part I.

"What would be the most common repair strategy for OEX or  XEO credit spreads once the short option has moved ITM (in the money)?

  • Should I have done something sooner?
  • It is a good idea to cover the credit spread when the premium doubles? 
  • If I do cover the spread, should I also roll over to next month using slightly further OTM options?" 

First, a clarification: When you write about to the idea of a "roll over" that refers to the strategy of closing the current position and moving it (i.e., rolling) to a longer-dated expiration. The strategy is based on the misguided idea that if you give the position more time to work, that your current situation (where you are losing money on the trade) may be reversed. That idea is very simplistic and, as described below, gets a lot of traders into serious trouble.

Yes, you should have done something sooner. The bottom line is that each trader has to know when the risk of owning a given position has increased beyond that trader's comfort zone. My comfort zone requires adjusting credit spreads before the short option moves beyond the strike price. The borders of your comfort zone probably differ. The important point is that you must have a risk-management plan that prevents account-killing, large loss.

 

Money Management

Some experienced traders adopt the policy of adjusting credit spreads when the premium doubles. From my perspective that is a poor plan. Such a rigid rule is inappropriate most of the time. For example, if you collect 50% of the maximum possible premium (i.e., $5 for a 10-point spread), then your adjustment point would never be reached because the spread premium never doubles to the theoretical maximum value of $10 before expiration arrives.

In addition, if your strategy is to collect a small premium (i.e., $0.15), the probability that you will be forced out of the trade is almost 100%.

Instead of such a rule, I suggest that each spread be considered on its own merits because it is not practical to attempt to repair all trades. Nor is it reasonable to adopt the identical repair strategy on every trade. Sometimes quitting a trade and accepting the fact that it has lost money is the best possible risk-management decision. At other times, it makes sense to repair the position.

The decision about when to adjust positions should be based on

  • Your personal tolerance for risk and the boundaries of your comfort zone.
  • The current risk (amount you may lose) associated with holding onto the position and the maximum possible loss that you can afford -- without hurting your account.

If you use "premium-doubling" as the trigger for repairing a credit spread, I would have no objection, as long as the original credit spread met certain criteria. For example, the premium-doubling plan is suitable when

  • The premium collected for a 10-point index credit spread is $1.00 to $1.50.
  • At least two weeks remain before the options expire. When less time remains, repair strategies are trickier to handle because the positions have significant negative gamma
  • Repairing (rolling) the position leaves you with a new position that you want in your portfolio. One of the problems with repairing a position is that some traders believe that repair is necessary, regardless of the situation. Consider a repair ONLY when you are very comfortable with the newly-rolled position. Rolling into a high-risk position makes no sense because the chance of incurring another loss (the original trade has already lost money) is high.

Those parameters are not set in stone. In fact they may not work for you. But the important point is to understand that the premium-doubling plan is inappropriate in many situations.

For example. let's say that you like the idea (I do not) of selling very far OTM credit spreads and collecting a small premium ($0.25 or less for a 10-point index spread).

Sure, this trade has a very good chance of being profitable. However, the profit potential is small and I dislike the high probability that the premium will double -- forcing you to lock in the loss. When you adopt the premium-doubling exit (or adjustment) strategy, then selling small-premium credit spreads is just not viable.

First, most of the time the market moves enough for a $0.25 spread to reach $0.50. That means repairing a trade that remains well within your comfort zone. No one likes to do that. Second, if implied volatility rises, the far OTM options are affected most. That means the spread that you sold @ $0.15 could easily trade at $0.30 -- requiring you to exit -- even when the index price is unchanged. Would you really be comfortable adjusting under those circumstances? I wouldn't.

Third, the bid/ask markets for the options are fairly wide. Let's say that you sell a spread for $0.20. It is very reasonable to assume that when you entered the order and were filled at $0.20, that the bid price for the spread was ~$0.15 and that the ask price was ~$0.35 or $0.40. How would you decide that the premium has doubled and that it is time to adjust? Would you use the ask price? You cannot do that because it would be time to adjust as soon as you made the trade. So that is obviously out of the question. Would you wait until the bid was $0.40? If you do that, you will have almost no chance of paying as little as $0.40 to exit. Would you wait and hope to get the order to pay $0.40 filled, or would you be anxious to exit (i.e., a good risk manager does not hesitate to do the right thing -- and that is to cut risk) and pay as much as $0.60 to exit? If the bid is $0.40, your cost to exit will be higher. This plan is not viable either.

Fourth, making all these trades costs money. Not only commissions, but slippage as well. When selling premium and hoping to earn money from time decay, we are better off trading as seldom as prudent. Never avoid a trade when it is time to manage risk -- but this premium-doubling repair plan does not pair well with low-priced credit spreads. 

If you agree that selling cheap premium does not work for you, then how about selling credit spreads that are not very far OTM? If you collect $4 for a 10-point spread, then your plan would not call for any adjustment until the spread reached $8. By that time the options would be fairly far ITM and there is nothing (good) than can be done to repair the position. The trade decision would come down to two choices: Exit and take the loss, or hold and hope for the best. Neither is an attractive choice.

For those reasons, the premium-doubling adjustment strategy has to be limited to certain types of credit spread. So, if you adopt that plan and use it judiciously, it may work for you. But this plan comes without my recommendation.

The last question
The last question is about rolling the position and is answered here.