Question about downside risk of S&P 500 or Russell 2000 index bull put credit spread options if the market crashes

Question:   I fully understand the advantage of an Iron Condor over either a single Bear Call or Bull Put spread, since at expiration only one of them could potentially cause a loss. However, since the market is more likely to take a much deeper dive on bad news, rather than a very large surge on positive news, would it be advisable to only play only Bear Call trades. I am concerned that some catastrophic world event similar to a 9/11 could wipe out much of my portfolio overnight if a substantial amount was invested in Iron Condors or Bull Put spreads. For instance, if 60% of a portfolio in invested in mostly iron condors (or bull puts), that 60% could be lost overnight. I have seen your portfolio of the 2008 crash and the loss was manageable. However, that crash happened over a period long enough that adjustments could be made.

Response:     I understand your concern.  In general, because we open very far out-of-the-money (OTM) 90% probability credit spreads, we tend to have enough time to close out our bull put spreads and/or make adjustments to cut our losses in the case of a market meltdown.   99% of the time, even when the market pulls back hard, we have time to get out and cut our losses, and we have a 5 year track record of keeping our losses below 10%, which is pretty good.

However, the October 2008 crash was different where we unfortunately ended up riding a few of our spreads down to where they went in-the-money (ITM).  This happened because in addition to the major indexes violently selling-off 3% to 5% per day, volatility also rapidly spiked up to record levels making it very expensive to get out of our spreads. We therefore decided to hold-on hoping for a short lived bounce so we could get out, but unfortunately that never happened as we all know.   So during the Oct ‘08 crash, we actually made very few adjustments to our bull put spreads, thus they they went ITM, and we were able to eventually get back 65% of our original risk capital purely by rolling our ITM spreads month-to-month, rolling down the strike prices of our spreads lower and lower each month, and waiting for the market to rebound a little.   This Oct ‘08 crash gave the MCTO team a good case study on what it takes to roll spreads and to recover a large % of risk capital after a massive crash.  It was painful to go through, but I’m somewhat happy that it forced me and my partner to become experts on rolling in order to preserve capital during a crash.

So per your concern of a one day, 15% or greater stock market crash where our bull put spreads immediately go ITM, we have a lot of experience with what it takes to roll spreads and we are confident that we can get back at least 60% of our risk capital, and possibly as high as 80% of our risk capital, depending on how fast the markets recover.  (An example of an event that would cause a one-day 15% crash is something similar to 9/11, or worse, the detonation of a  nuclear device in a US city by terrorists, which is the type of event that could take the markets down 15% or more in a single day)

Please keep this in mind as you interview other credit spread advisory publishers. Very few, if any, credit spread newsletter editors have experience in rolling.  Most don’t bother with rolling and just throw in the towel and let their subscribers lose 100% of their risk capital.  For us, that’s unacceptable and we fight to the end to preserve our capital using advanced rolling techniques that we practiced and refined during the Oct ‘08 crash.

Comments (3)

Donald SassanoNovember 17th, 2009 at 8:15 am

Hi Brad:

Thanks for publishing this exchange — I think its a very thoughtful response to a question that may be in the back of many investors’ minds. If you have a moment, can you please comment on the writer’s thoughts about relying more on call spreads in order to avoid any sudden sell-off. Curiously, the only anxious moment I have had this year was in September when the market continued to rise and my call spreads were briefly in the money (as I recall based on some extraneous remarks by Bernanke). Thanks.

Steve PetrieNovember 19th, 2009 at 12:22 pm

I am glad to see someone raise the concern about potential loss related to a market dive. This risk cannot be over stated. The October 2008 crash created what I call a Perfect Storm for loss of capital. The Russell 2000 had been bearish at the last week of September. It was a good time to open Bull Put spreads. Then a week later the index became bullish so open a few Bear Call spreads. Then the index became bearish again. Load up on more Bull Put spreads. So now we are sitting just prior to the crash with a couple of Bear Call spreads and a lot of Bull Put spreads. Here is the important point, We have a lot of open spreads about 1-week before expiration. We are filling so good that we have carelessly tied up most of our portfolio as risk capital. Our employer unexpectedly asks us to travel out of town to take care of an important client. We are in our hotel room and open the laptop to observe the Russell 2000 starting to fall. We close out the Bull Put spread that is about to go in the money. Then we check later. The index is still falling. We close out another Bull Put spread. Then we panic. We do not have enough cash to roll the remaining spreads into the following month. We have to go see the customer and do a training. You can see where this is going. I lost most of my portfolio. Trust me. You do not want to live through an experience like that. Limit your exposure to loss. Do not ever become lax and think trading Iron Condors is easy money. You make some money a little at a time if the spreads expire worthless each month, but can lose money very quickly if more than one or two spreads go in the money. Be careful.

Tom BesslerNovember 19th, 2009 at 1:09 pm

Brad, What about hedging somewhat the risk of a downdraft? For risk management, I don’t want to let a position get too far negative (some traders say that if you expect to make $1000 on a position that if it starts going against you that should get out if the position value drops to ($1000), about what you had hoped to make, and not ride it down lower, even if still notably above the exercise price. If the position drops into the money and doesnt recover before expiration, you’re looking at a theoretical full loss of $10,000 loss for 10 condors. Even if this can be mitigated, I wouldnt want to absorb a large loss.

One way to have breathing room is to use say 1/3 of the premium earned to buy a protective put a few strikes above the short put strike (say buy one put at 550 if you have sold a quantity of ten 530/520 put credit spread); as prices decline and the put spread comes under pressure with an increasingly negative valuation there will be some offsetting gain on the long 550 put to let you adjust withhout incurring a more painful loss. It does eat into the return but dampens the risk and helps reduce worry if the price whipsaws during the month.

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