Credit Spread Exit Tactics

Posted on February 27th, 2013

About 2 weeks ago we wrote about entering in to a credit spread in our post: March High Probability Credit Spread TradeThis gave us the criteria to use when entering this kind of trade. Today we’re going to talk about exiting when things start to go wrong.
 
As we said in our post from the 14th, by definition, credit spreads have a max loss of the difference between the strikes minus the premium generated, so what you put up for the trade is what you can lose. Basically all the assets allocated to the spread are at risk. Avoiding a full loss is vital to staying liquid and surviving to trade another day.
 
Typically there are 2 tactics managers use to avoid the full loss scenario; closing to cash (i.e. a full exit) or rolling the risk forward to another month. Most managers choose the second. This is because selling early when there is still a high probability of success seems to take an unnecessary loss that will eventually work itself out. In these circumstances, managers decide to weather short-term market pops and drops, like we had earlier this week, and still make their payout the next month.  They establish strikes farther away from the market and stand to gain from only a reversal lasting only a few days. These positions are usually written for the following month and create premiums that can actually be deeper out-of-the-money for a higher credit.  Those are all good things for a credit spread strategy.
 
At Buy and Hedge though, we typically follow the “close to cash” method. That means that at some point our exit criteria are met and we close out the position within the same month. We do this for three reasons:
1-When the market turns against this trade for longer than a 2 or 3 day period, the losses get harder and harder to roll out of. A broad market reversal will have those who used the roll method on the wrong side of the market for a longer period of time while waiting for a reversion back to the old norm. This doesn’t always happen.
2-We like cutting our losses early and going to cash because it allows us start over from scratch. Doing this usually results in a bias switch and play the direction that the market has decided to move.  In other words, if we were bullish with a short put spread and the market dropped down enough, we would close out the put spread and get into a bearish credit call spread.
3-Closing to cash keeps us liquid and we have found that clients prefer to have a strategy the gets to cash every month vs. longer-term commitments on losing trades.
 
Historically, the exit to cash method has proven to prevent catastrophic losses during market reversals and allowed us to benefit from a new trending market. The down side to the "close to cash" method is that exiting usually was unnecessary when looked at in hind sight. In other words, although there was a market turn, the original options would have closed out worthless if we just had patience. As it turns out, we make the choice of lesser risk when faced with sticking it out or protecting the underlying assets. By protecting the assets, we mean we closed to cash and started over. As our book states, we’re all about understanding our risk and knowing how much is at stake. For this spread trade, that risk is catastrophic if the spread trade goes to its worst outcome. Closing to cash when this high probability spread moves the wrong way keeps us as conservative as possible within an already aggressive strategy.
 



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