Thursday, April 16, 2009

Mail Time

Let's tackle a question from Rohit, in response to my Stuck in a Rut post:

Thanks for the post. A question pls: for credit spreads like this one (bull put or the bear call), you would want time decay to work in your favor. In that case, wouldn't it be better to put these spreads on about 2 weeks before expiration? this way the time decay is the fastest and you gain the most. Am i thinking about this the right way? Thanks in advance.
-Rohit

Hey Rohit,

Let me preface my answer by stating that option trading involves trade-offs. Whether you're trading credit spreads, covered calls, naked puts, or any other option strategy under the sun, there will always be trade-offs between using long term vs. short term or ITM vs. OTM options. Because of these trade-offs its tough for anyone to really say whether one method is "better" than another. It comes down to personal preference and whether or not you're comfortable with the risk-reward characteristics of the method you choose. My recommendation for anyone trading options is to get to the point where you understand these trade-offs and the underlying rationale of each strategy. Don't take any thing I or any other person or resource says at face value... always ask "why?". When you understand the "why" you're well on your way to properly using options in your trading.

First off, credit spreads (Bull Put & Bear Call) are positive theta trades, thus you do indeed profit from time decay. Theta increases exponentially as we approach expiration. I've posted this time decay graph in my previous post on Theta, but it bears repeating:
Due to this rapid increase in time decay in the final few weeks to expiration it is quite alluring for option sellers to enter positive theta trades with only 1 or 2 weeks to expiry. In that regards, your thinking was correct. However there are a few trade-offs to entering a credit spread a mere 2 weeks to expiry vs. a longer time frame like 4-6 weeks.

Trade Off #1: Lower probability of profit or less premium
With only 2 weeks remaining, OTM options will not have as much value left. In my example, the RUT was trading at 430 and I entered a 5 1/2 week put spread 80 points OTM (350-340) for $1 credit. If I tried to enter a put spread that far OTM with 2 weeks remaining I probably would have only received around $.30 credit.... not nearly enough to make the trade worth it. Consequently, to make a 2 week put spread feasible, I would have to use closer to the money options if I wanted $1 credit. Let's assume I could sell a 390-380 put spread for a $1 credit. So the 4-6 week credit spread allowed me to go 80 pts. OTM for $1 credit, the 2 week credit spread only allowed me to go 40 pts. OTM for $1 credit.
Bottom Line: Entering a 2 week credit spread vs. longer term will bring in less credit (if using same strikes) or I'm going to have to use closer to the money strikes which diminishes my probability of profit.


Trade Off #2: Higher Gamma Risk
Gamma risk is tad bit more complicated to understand... so it may take time (and witnessing it play out in your own trades) to fully grasp the concept. Here's a quick primer on Gamma: Gamma is the rate of change of Delta, thus it measures how quickly my Delta will change. Gamma is highest for short term, ATM options and lower for long term ITM or OTM options. As Gamma increases it becomes increasingly difficult to manage your delta risk. Suppose I consistently delta hedge my option positions (to keep it neutral or within an acceptable range) by buying and selling stock. If the delta changes slowly (a low gamma), it is relatively easy to make adjustments (buy or short stock to get position delta back into my comfort zone) and I shouldn't have to adjust that often. On the other hand if delta changes rapidly (a high gamma), then I have to delta hedge much more frequently(a pain in the neck, especially if you've ever tried to delta hedge a short ATM option into expiration week).


One of the correlations between Gamma and Theta is they both increase as you get closer to expiration; so although entering credit spreads really close to expiry to capitalize on the higher theta is tempting, you significantly increase your gamma risk at the same time. This is often why option sellers close their short option positions a few days prior to expiration (sometimes even if there is still $.20 or $.30 left in an OTM option). It avoids having to hold those short positions when gamma is the highest.


So, my personal preference is to sell credits around 4-6 weeks out so that #1 I can go far enough OTM to receive an acceptable credit for a high enough probablity of profit and #2 I avoid the high gamma risk that arises close to expiration.

Some credit spread traders prefer to sell them even further out in time, like 13 weeks. This approach gives them the ability to sell credit spreads even further OTM, as well as further decrease gamma risk.

Now that you know the trade-offs, you simply need to decide what best fits your comfort level.

Tyler -

5 comments:

Anonymous said...

Tyler,

I noticed that you seem to advocate at least $1 credit for a $5 spread (for your spread strategy) for OTM spreads....am I getting it right? if so, would you also then think its ok to get $0.50 credit for $2.50 spread?

I guess what I am after is that: is there some formula or some guidelines you use for your credit spread strategy...say 20% yield or better for 1month options (basically $1credit for $5 spread)...remember your broker also has margin requirement that baiscally freezes up your cash for that time period, so essentially it is like getting the yield on your money while doing the credit spreads...am I getting that right? I will like to hear your thoughts regarding spread/credit ratio, if you have any.
Thanks.

Rohit Agrawal said...

Thanks for the detailed response Tyler. I also have a similar question to the new comment on this post w/ regards to credit / spread ratio.

Regards,

-Rohit

Tyler Craig said...

Anon,

Thanks for the question. "Advocate" may be a little strong. Allow me to qualify my examples: Their based on my own personal preference, which is by no means a recommendation for anyone else.
I typically play with the RUT when trading credit spreads and because I'm placing $10 spreads, $1 is the bare minimum of what I'm willing to accept. That comes out to about an 11% return. I do also play credits on the SPY occasionally (usually $4 or $5 wide spreads). Because those have very tight bid-ask spreads I sometimes enter spreads that receive as low as a $.35 credit. However, I would never enter a $5 spread on a normal stock for $.35 (bid-ask spreads are a lot wider).

But it's completely personal preference.

My very unscientific guideline is simply to make sure I bring in enough credit to make it worth my while.

If your satisfied with $.50 on $2.50 spread, then sure it's a valid trade. I don't really play with $2.50 spreads. Since it is such a small spread, I would make sure it has tight bid-ask spreads. It's tough to exit a spread like that early if the bid-ask spread on the options are wide.

As far as the broker requiring enough margin requirement to cover the risk.... yeah that's correct. So if I receive $1 credit for a $10 spread, the $1 plus $9 of my own money will be held aside until I exit the trade. But that's true of just about any trade of this nature.

I suppose you can think of it like "getting the yield on your money while doing the credit spread", but remember it's not a guarantee- you still have to manage the risk & have an exit strategy if the underlying moves adversely.

Tyler-

Anonymous said...

Thanks.

OK.. I will admit that this strategy is new to me, and I am intrigued as I also came across folks who favor Iron condor strategy. Given my background, help me get over the following psychological hump, if you will

I am a value player meaning buy low sell high (mainly stocks) but when I look at accepting $1 credit for $5 potential risk, I agonize.

I understand one of the way to manage this risk is through position size and maybe rolling up/down. At the same time looking at the stock charts for any resistance/support areas.

But still, how should I address my concern of risking $4 for a potential $1 reward?

Any advice?

Tyler Craig said...

Anon,

The missing variable for you seems to be probability of profit. It makes all the difference- Risk-reward maybe a crucial variable to assess in stock trading, but it's not near as important when it comes to trading vertical spreads IMO. I'll elaborate on this concept in my next blog post (probably next Monday).

Tyler-