Credit Spread Trade Patience

by Jay Pestrichelli on November 26th, 2012

It’s been a while since we discussed the high probability credit spread trade, but here is one guideline that can get lost in the excitement of entry and exit criteria. That lesson is patience. When there is no trade, don’t force it.  As a reminder, we like to place trades that have an advantageous risk/reward ratio. So when that ratio doesn’t skew to our advantage, it means we wait till there is one that does.
 
As of the open this morning, we are in an environment where the trades just aren’t worth taking the risk for the deep out-of-the-money credit spreads.  And if you can find a trade that would work, it would not be far enough away from the current market for comfort.
 
Right now the reason for the December trade being on hold is the low volatility. As a reminder, the OTM credit spread makes its money by essentially selling volatility. The higher the volatility, the higher the premium generated by selling options. This tactic profits from the fact that there is a risk that the spread goes in the money.  When that risk is low, there are fewer speculators willing to take that bet. Right now, the volatility on the VIX is at levels lower than before the election. So we are left in a situation where there just isn’t enough premium worked into OTM options to generate sufficient credits.
 
Historically, waiting out an environment like the one we are in today pays off. Only one time in the last 2+ years of us running this trade have we skipped a month. That means that if the trade isn’t there at the 4 week mark, just wait and it will emerge. Those using this tactic don’t care if they make their money in a single day or if it takes 4 weeks. And actually, the less time the position is in play, the lower the chance of a catastrophe.
 
Personally, I’d prefer to make this trade with less than 2 weeks to go, but it’s just usually not a possibility. Perhaps it will this month. Let’s face it, with all the talk about the fiscal cliff and government gridlock, there’s a good chance we’re in for a rocky December. That means that volatility will rise and we can get into a credit spread that will meet our risk criteria. We just have to be patient.
 


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