Exiting High Probability Credit Spreads
by Jay Pesdtrichelli on December 28th, 2012
On Wednesday we posted how to enter into the high probability credit spread strategy, so today we’ll discuss when to exit them. As you’ve heard in just about all aspects of investing, knowing when to exit is more important than knowing when to get in. That rings true here as well. This is because all the money set aside for the requirement of this position is at risk. Said another way, if the options of this spread expire in-the-money, then all of the requirement is lost.
In our example on Wednesday we looked at a spread on RUT that sold the Jan 740 put and bought the 730 put for a net credit of 0.30. The requirement on this trade is $9.70 per contract. If the RUT was to be marked at any price below 730 on January 18th then this trade would lose $9.70 per contract. This is a situation we want to avoid at all costs.
At the time we marked the spread, RUT was trading at 840. That is about 13% away from the 730 level and is why this is considered to be a high probability trade. Currently RUT is around 835 and the spread premium is 0.32. That means so far, in these last two days, the trade has lost 0.02. Not so bad considering the market has been down all week and rising in volatility.
The criteria we use for exiting is when the spread value doubles from the time we sold it. That means a spread sold at 0.30 would prompt an exit if the spread rose to 0.60. This is a round number that makes it easy to remember, but there are a few rules to remember when this happens.
First, the reason we exit at 0.60 (that’s a 0.30 loss) is to never have to experience the drop of 9.70 we outlined earlier. We want to avoid this at all costs.
Second, since this strategy has a high probability of success, it will work most months. In our experience as well as back-tests, we find that this strategy has worked on average for 11 out of 12 months when exiting at the double mark. So taking a hit of only one month worth of income, in this case 0.30, allows us to make it back up the following month. Earning 3% for a net 10 months isn’t a bad way to win in the market and is exactly what we did in 2012.
Third is the 3 day rule and applies to market timing. We can’t always know or time when the market is going to go up or down. So at times, we will see our credit spread go through a doubling in just the first or second day of the trade if the market moves dramatically against it. However, there is still a high probability of success so we don’t want to exit prematurely. In these situations we want to wait for 3 days before exiting the trade to allow for a settling of the strikes. If after 3 closes, the spread is still more than double, it’s time to exit.
Fourth is the bias switch. In cases where we have to exit the trade, we want to be able to make some of the losses up. In this case, we switch our market bias from a bull put spread to a bear call spread. This intends to generate some income on the other side of the market by adopting to the direction. Entry rules will apply of course, but you’ll want to prorate the reward rate as time will have expired since your entry. That means for a 3% risk with only half the option period left, you should be satisfied with 1.5% in return on the new trade.
There is one more important risk to disclose on this trade and that is the unforeseen market catastrophe. While this has only happened a few times in history, there are times that the market will gap down 5% or more from one day to another. In these circumstances, this trade will feel the most pain, especially if that gap down puts the spread’s strikes into the money. An example of a big down open was after the events of 9-11. An additional challenge was that the market stopped trading for 3 days and left those waiting to exit with no means to do so until the market finally opened.
While mathematically there is the chance to lose all of the trade maintenance, historically we have not been able to find a situation where it occurred. But that doesn’t stop us from watching out for it. Any money put into this strategy should be money that you consider high risk for this circumstance alone even though it has a high probability of success. With high return comes high risk and that is true with this strategy.
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