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

By: Tom Bessler

Tom Bessler — Thu, 19 Nov 2009 19:09:18 +0000

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.

By: Steve Petrie

Steve Petrie — Thu, 19 Nov 2009 18:22:01 +0000

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.

By: Donald Sassano

Donald Sassano — Tue, 17 Nov 2009 14:15:06 +0000

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.