Want To Talk About Exits on Credit Spreads? Me Neither.
Tuesday, December 12, 2006 at 08:51AM
I received a few comments about exiting credit spreads prior to expiration. A few comments include how Implied Volatility changes 
the pricing on the options, how losses are worse buying back early, violation of a break even point, daily fluctuations showing profits/losses, exits based on greeks, etc.
The credit spread strategy is used to withdraw option premium out of the market at a low risk area. Basically selling these at places the market is not likely to hit. If you find yourself struggling with exiting spreads early, it is likely that the exit is not the problem. The problem is probably your entry or how aggressive you are playing spreads. Remember that the main objective is to get these spreads to expire worthless and keep the initial credit. Here are a four rules to consider...
Rule #1: Do not sell time.
Try to aim for front month expirations. Even if they expire in a week or two, this is a good thing!!! Don't sell lots of time since you have a higher probability of the stock moving against you over this time.
Rule#2: Don't forget rule #1
Rule#3: Sell these spreads at a strike that the market/stock will not hit!
This is one of the most important aspects. If you want to keep the credit, keep the trade away from the price of the underlying instrument. Beyond key support/resistance levels, way out the money, etc.
Rule#4: Timing is everything.
Perhaps your timing is lousy? I know when I first started trading I was so furious that I couldn't get my exits right. After doing further research, I found that my entry was horrible. As I fixed this it made exiting these trades so much easier. Make sure your entries get you in the issue as early as possible.
Now that I have issued the rules, let me retort to a few of the comments I received...
"Implied Volatility effecting the options"... Yes, both options will increase in value if IV rises. This would make the spread more expensive to re-purchase....BUT...this should not offset the decay of time. If you keep these options short dated time decay should be able to over-rule this factor. More importantly, if you keep these spreads away from the stock price it won't matter. As long as you are not in danger of gaining intrinsic value they will expire worthless.
"Losses seem to be worse buying back early"...This can be the case, especially if the price moves too much against you. Keep in mind that spreads will fluctuate in value all over the place. What is important is that you focus on the chart, and not on the gain/loss balance in your account.
"Breakeven points"...Don't tell anyone, but breakeven points are meaningless. At expiration you can use this for some reason, but even then it won't matter. When trading spreads never use a breakeven point for an exit unless it correlates to support, resistance, or some other predetermined exit.
"Exits based on greeks"...Never use a greek as an exit.
Leave additional questions in the comments section. I will try real hard to supply answers.
the pricing on the options, how losses are worse buying back early, violation of a break even point, daily fluctuations showing profits/losses, exits based on greeks, etc.The credit spread strategy is used to withdraw option premium out of the market at a low risk area. Basically selling these at places the market is not likely to hit. If you find yourself struggling with exiting spreads early, it is likely that the exit is not the problem. The problem is probably your entry or how aggressive you are playing spreads. Remember that the main objective is to get these spreads to expire worthless and keep the initial credit. Here are a four rules to consider...
Rule #1: Do not sell time.
Try to aim for front month expirations. Even if they expire in a week or two, this is a good thing!!! Don't sell lots of time since you have a higher probability of the stock moving against you over this time.
Rule#2: Don't forget rule #1
Rule#3: Sell these spreads at a strike that the market/stock will not hit!
This is one of the most important aspects. If you want to keep the credit, keep the trade away from the price of the underlying instrument. Beyond key support/resistance levels, way out the money, etc.
Rule#4: Timing is everything.
Perhaps your timing is lousy? I know when I first started trading I was so furious that I couldn't get my exits right. After doing further research, I found that my entry was horrible. As I fixed this it made exiting these trades so much easier. Make sure your entries get you in the issue as early as possible.
Now that I have issued the rules, let me retort to a few of the comments I received...
"Implied Volatility effecting the options"... Yes, both options will increase in value if IV rises. This would make the spread more expensive to re-purchase....BUT...this should not offset the decay of time. If you keep these options short dated time decay should be able to over-rule this factor. More importantly, if you keep these spreads away from the stock price it won't matter. As long as you are not in danger of gaining intrinsic value they will expire worthless.
"Losses seem to be worse buying back early"...This can be the case, especially if the price moves too much against you. Keep in mind that spreads will fluctuate in value all over the place. What is important is that you focus on the chart, and not on the gain/loss balance in your account.
"Breakeven points"...Don't tell anyone, but breakeven points are meaningless. At expiration you can use this for some reason, but even then it won't matter. When trading spreads never use a breakeven point for an exit unless it correlates to support, resistance, or some other predetermined exit.
"Exits based on greeks"...Never use a greek as an exit.
Leave additional questions in the comments section. I will try real hard to supply answers.
Reader Comments (5)
Correct! Never risk the max loss, try and find a dollar value that represents the worst case scenario. Then buy back for a loss. I have never used delta to gauge that, but sounds interesting.
Solid addition, thanks for the contribution!
Jeff
Thanks for the fantastic blog! Although still new to options, I have learned a ton from you and all the contributors.
Question, though for you on a couple of posts back on support bounces. What do you use as confirmation? Do you look at intra day charts? Volume? What constitutes a successful bounce play? I did a search on the entire blog and couldn't find confirmation details. Any help would be greatly appreciated.
Thanks!
AM
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