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expire, the credit spread on the RUT and SPX (classified as broad based indexes) are cash settled, so cash would be withdrawn from our account.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:     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.

Answer:   Rolling-up by taking the profit of a spread that already generated profit and rolling the profit into a new spread that has strike prices closer to the underlying index can be a good strategy.  However, the new spread is a separate trade and it has to make sense per all of the analysis that we do.  So when you ask the question -  “Does rolling our profitable spread into a new spread that is closer to the underlying index increases risk?”, as long as the new spread stands on its own per fresh analysis, the risk/reward will be balanced and acceptable.

For me personally, when I feel confident that the underlying index will hold above, or below, my short strike prices of my spreads, and if I have reasonable buffer between the short leg and the underlying index, and if I don’t need to free up the cash, I’ll just let the credit spreads expire worthless.   But if I have any hesitation at all, I’ll close them out early to take the profit and to reduce risk.   Therefore on this trade, I’m probably going to hold onto my SPY Nov 92/94 bull put spreads, and I’ll start bringing in additional premium with the new SPY Nov bull put spread that we recommended in the November 6th advisory