Answer:   You could if you wish, but I don’t recommend it.  In order to buy back the short leg it will be really expensive.  And, I’m not convinced that the market will climb any more.  On the other hand, if I thought the market was going to continue to rally for the next week, this would be a good strategy.  Let’s look at the numbers as of March 11, 2010:

 To close out the RUT Mar 680/690 bear call spread it would cost a debit of $2.55

To BTC the 680 leg it would cost a debit of $3.85

To STC the 690 leg we would collect $1.30 credit

3.85-1.30=$2.55

 You can see that if we just hold onto the long 690 call, it will cost us $1.30 and the RUT would need to continue to rally in order for this long 690 call to pay off.

Answer:   In a very rare occasion that we get stuck with ITM credit spreads, we will usually roll them and keep them alive….and eventually get 50% to 70% of our money back.   Unfortunately, and fortunately, I’ve become an expert on rolling because some of my spreads went ITM during the Oct 2008 crash, and after rolling them I got back 65% of my maintenance.   Not bad for a total melt-down.  (Just as a side note, most credit spread traders, including editor-in–chief’s from other credit spread newsletters don’t have experience in rolling because most just throw in the towel and let their subscribers take a total loss.  I personally hate to lose money and will fight to the end to get back at least some of my money) 

Answering your question specifically, if some of our spreads went ITM and we didn’t want to roll them but just let them expire, the credit spread on the RUT and SPX (classified as broad based indexes) are cash settled, so cash would be withdrawn from our account.   If the spread went completely ITM and we let it expire, we would lose all of our risk capital, which is the required maintenance less the premium collected.

Per options on the SPY and IWM (which are ETFs that track at 1/10^th the value of the S&P 500 and Russell 2000 indexes, respectively) the ETF shares would be PUT to us where we have to buy the shares at the strike price and the shares would be deposited into our account.

Again, in general with this situation, and this is only for the emergency case where the stock market crashes 12% or more in just a few days and we get stuck with ITM bull put spreads, we will roll our spreads month to month and there is a very good chance we’ll get back at least half of our money, and more like 60% to 70%.

Response:   Regarding liquidity.…yes, if too many folks start trading index credit spreads, for example on the S&P 500 and Russell 2000 indexes and ETFs, the risk/reward characteristics of our credit spreads will become less attractive.  So far, however,  there seems to be plenty of  liquidity and the placement of the strike prices are still good.   Luckily, credit spreads are a lot harder than they look, so a certain % of participants get hit every month, scaring them and washing them out..…so it’s my guess that there will be plenty of liquidity for a long time to come.