# Risk Management for Credit Spreads



## ducati916 (24 December 2006)

When placing credit spreads, what [if any] additional risk management ideas have you found effective?

*Hedging with stock
*Closing position for maximum loss [@ expiry or before]
*rolling strikes
*closing short position & keep long position open

Any preferences?
Why?

jog on
d998


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## wayneL (24 December 2006)

ducati916 said:
			
		

> When placing credit spreads, what [if any] additional risk management ideas have you found effective?
> 
> *Hedging with stock
> *Closing position for maximum loss [@ expiry or before]
> ...




Duc

A lot depends on where the strikes are in relation to the underlying and the delta of the spread.

*personally*, allowing a maximum loss would be the last thing I would allow to happen.

Each situation is different but:

* hedge with stock - yes sometimes as a temporary measure
* closing out - yes, see below also
* rolling out - yes, see below also
* you can hedge with an opposite credit spread i.e. create an iron condor and then subsequently roll or close if necessary.
* depending on the "moneyness" of the strikes you can create a backspread by buying more of the bought leg (not so good if the spread is far OTM)

The possibilities are endless and will depend on how the trader likes to trade.

I like to hedge first and then close or roll as necessary with the opposing spread on.

Cottle has a lot to say about "option metamorphosis" in "Options - The Hidden Reality" www.riskdoctor.com

If you haven't read it, I think it would be right up your alley.

Cheers


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## ducati916 (26 December 2006)

*enzo*

Thank's for the link, very interesting.
Just a quick observation on Options, again, as with trading stocks, or futures, the sensible trades are actually very contra-intuitive. I have been calculating some positions, and, almost the exact opposite of my initial emotional selection, mathematically provides the rational selection.

One further question.
When have you found to be the optimal time frame to roll, if you have selected rolling as the correct response? I am assuming the less that you are required to roll, the better...............intuitively, this suggests near expiration.

jog on
d998


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## Mofra (26 December 2006)

ducati916 said:
			
		

> When placing credit spreads, what [if any] additional risk management ideas have you found effective?



Howdy Duc,

Haven't had to put it into effect yet - but I always tend to prepare for a contingency of a movement in teh underlying to close to ATM on the short leg. This is far more taxing on the synapses than a sharp movement to put both/all legs ITM, as max loss for me is a write off, learn from it, get out (if slippage allows) & move on. I prefer not to roll both legs as I have found slippage tends to erode the risk/reward calcs & if I have it wrong the first time, I find it easier to re-assess the situation without the worry of salvaging a position.

Depending on the situation, I would favour a write on a further OTM series & close out the short ITM series for a loss, effectively creating a net debit spread which is at least providing you with the correct delta position for the movement in the underlying. I would want this to be fairly close to expiry & if the initial sharp movement warrants it I would ensure the long/short legs are ratios accordingly. Otherwise, an exit at less than max loss at least saves some capital and I can start planning the next position.

Being a part timer I tend not to add too many legs to a position if I can avoid it & I prefer not to add stock to a positon as I prefer to hold stock on the basis of value rather than hedge.

Good thread to provide food for thought, 

Cheers


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## ducati916 (26 December 2006)

*Mofra & enzo*

I quite like the idea of building an Iron Condor credit spread, with the assumption that one side must lose, and I am therefore looking at how to best manage the inevitable move to a losing position.

By creating a double credit spread, you reduce your total risk to the spread less two credit spreads; thus hedging the losing leg with stock ATM, should eliminate the spread risk and create a fixed profit if you can close out the stock hedge for at least the remaining unhedged spread. The more of the spread you can capture in the day move, the greater the profit that can be locked in.

Rolling, would be a last ditch effort to salvage a position that had run away and the hedge had been missed, or you had been whipsawed out of it.
Theta decay would I imagine make it rather difficult in the front month, you might have to roll to the next expiry month.

Thoughts?

jog on
d998


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## wayneL (27 December 2006)

ducati916 said:
			
		

> *Mofra & enzo*
> 
> I quite like the idea of building an Iron Condor credit spread, with the assumption that one side must lose, and I am therefore looking at how to best manage the inevitable move to a losing position.
> 
> ...




One side need not necessarily lose, the price can close between the sold strikes.

There are quite a few different philosophies regarding iron condors. 

Some like to write the credit spreads a loooooooong way away from the price action. On face value risk/reward is absolutely dreadful, but of course probability of profit is commensurately higher.

On the other hand, others are quite prepared to write them closer to the price action, and are quite comfortable with making defensive adjustments as often as appropriate.

There are different ways of defending. Here is one bloke who has done up a bit of a video on condor adjustments with some comments on strikes selected etc. http://www.repairdudes.com/junky/RUT ic combo.html

I like hedging with stock prior to further adjustment, but the downside is that I am adding a delta adjustment that has no gamma factor attached to it, so adds black swan risk. Nothing wrong with this as long as the trader is aware of it. I use it as a temporary hedge, prior to possibly rolling strikes or some other action. (as you rightly point out, time till expiry can complicate the issues)

What I'm trying to get to is that there are lots of ways of dealing with threatened strikes, and each will have its advantage and disadvantage. The important thing is to have the thinking cap on when adjusting and for the trader to be aware of the new risk profile. In other words, there is nothing wrong with what you suggest, as long as the risk profile is satisfactory to you.

****reading through this doesn't much sense to me in my Boxing Day stupor, hope you know what I'm tryng to convey.

Cheers


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## ducati916 (27 December 2006)

*enzo*

I've placed a credit spread on my favorite, BIDU on the Call side only at the moment & 10 contracts

Sell Strike $120 @ $1.75
Buy Strike $125 @ $1.00
Credit $0.75
Total Risk assumed = $5000.00 less $750 credit = $4250.00
Return on assumed Risk = 15%

Calculated probabilities;
Expire ITM = 13.8%
Expire Worthless = 86.2%
Expire < $120 = 74.9%
Expire between $120 - $125 = 11.3%
Expire > $125 = 13.8%

I'll see how this works out through the January 20 Expiry date.

jog on
d998


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## wayneL (27 December 2006)

Cool!

I'll be interested to see how it unfolds... good luck.


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## ducati916 (27 December 2006)

wayneL said:
			
		

> Cool!
> 
> I'll be interested to see how it unfolds... good luck.




And if it goes t1ts-up, you can help in the analysis of saving it!

jog on
d998


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## ducati916 (28 December 2006)

Just placed at the close, a second credit spread trade;

DIA
Expiry Jan.20 2007
Sell $125 @ $1.20
Buy $127 @ $0.35
Credit = $0.85
Total Risk = $2000 - $850 = $1150
Return on Risk Capital = 42.5%

Fair Value = $1.15
ITM probability = 53.5%
Expire worthless = 46.5%
Gotta love the 50/50

Dow was rising on Auto's and Housing.
The bet, is on a January pullback.

jog on
d998


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## swingstar (28 December 2006)

duc, how did you work out the probabilities on where the SP will be at expiry?


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## ducati916 (28 December 2006)

swingstar said:
			
		

> duc, how did you work out the probabilities on where the SP will be at expiry?




From inputting all the greeks and the various strikes & expiry dates.
This is how the greeks can be used, to calculate quite precisely the amount of risk you are assuming, and the probability that the risk will stick.

However, I wouldn't put too much credence into any of the calculations at the moment. I included them, to add a context to the positions.

Credit spreads can be aggressive [DIA] or conservative, [BIDU] when assessed from a purely *probabilities* calculation.

The risk/reward skew on credit spreads is an ugly one, but seemingly rational *if* they play out to their probability of success [failure] therefore I have included one that is aggressive, but a higher return on risk capital with DIA @ 42.5% & conservative, with 15% return on risk capital with BIDU when measured as a probability.......

I'll see how they work out through January.
jog on
d998


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