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8 Adjustments For Credit Spread Positions Under Pressure
- 1. Eric Hartford
October 2006
8 Adjustments for Credit Spread Positions under Pressure©
1) Do nothing, ride it out, take the loss at expiration, needs a countertrend move. At some
limit this is not feasible, due to the extremely high risk to reward ratio of credit spreads.
2) Exit to close and take the loss. Without further adjustment, a trader should have a stop
loss limit in mind before entering any trade. The next three adjustments that follow (3-5)
include closing out the original trade in some form.
3) Roll away in strikes same month, take a smaller loss, but leave the door open to greater
losses. Buying back just the short and leaving the long in place if one expects the trend
to continue, can work, but one needs a sell target, as well as a time stop to sell the long.
3a) For each bought back strike, one can sell a multiple of farther out strikes or
new spreads ( ie- “butterfly your guts out”). For example a short 1500 – 1520 call credit
spread, could be butterflied by; buying back the existing short 1500 to close, selling two
1510 calls, and buying one additional 1520 call. This raises the strike at which the seller
starts to lose money, but leaves exposure and margin unchanged. However, it doubles
the rate at which one loses money, once the short strike is crossed, without further
adjustment.
4) Roll out in time at the same strike, take a smaller loss than 2). This adjustment just
means closing an unfavorable trade and entering a new trade the following month, and
prolonging the stress. Usually 5) is preferable, unless planned news after expiration
(think FOMC meeting) could spark a reversal
4a) If enough time remains on the front month, buy back the short to close, but
leave the long further OTM hedge in place and short the following month w/ a reverse
calendar spread. At expiration of the front month, the naked short needs to be bought to
close, or re-hedged, by buying a further OTM strike.
5) Roll out and away, net even, looking for a trend reversal. One can employ the same
reverse diagonal calendar approach as 4a). This is actually preferable, as a front month
strike under pressure is not relieved by selling more time at the same strike.
6) Jump in front with a long option hedge, buying closer to the money, but risking the
cost of the longs. One needs a sell target on the long, as well as a time stop. This is a
major departure from the strategy of selling premium, to become a buyer.
6a) Jump in front with a debit spread- lower cost alternative, but still at risk
7) Futures hedge – takes $15K margin per future, more than allocated to each trade
7a) Short futures in front of (closer to at-the-money) short put spreads
7b) Long futures in front of short calls
8) Synthetic future hedge, closer to the money
8a) Short calls/buy puts against short puts, or
8b) Sell puts/buy calls against short calls
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