Exit strategies for Credit Spreads

11 Jun

In this example a PCLN bull put credit spread.

Bull put credit spread for Priceline :

Sell 1 DEC 600 strike put @-$11.10 (-$1,100.00 per 1 contract)

Buy 1 DEC 595 strike put @ $10.20 ( $1,020.00 per 1 contract)

Initial net credit = -$ 0.90 ( $ 90.00 for 1 contract spread)

Maximum risk / margin requirement = $ 4.10 ( $410.00 for 1 contract)

Percent maximum return = 22% ($0.90 max. gain / $4.10 requirement)

What adjustments might we use?

There are basic adjustments that spread investors use to reposition their trade or attempt to lower their losses. The first is fairly obvious but not really an attractive scenario.

Adjustment 1: Liquidate the Spread

If PCLN drops to our mental stop point at any time we can simply chose to liquidate the spread and take a loss on the position. This adjustment is not desirable as a loss will be realized, but it is a defensive move to prevent larger losses if the stock continued to move against us. The action, or order, we would use to liquidate the spread would be: Buy to close DEC 600 put, sell to close DEC 595 put. If this happens shortly after the spread is open we will realize a larger loss compared to liquidating the position if our lower target is hit closer to expiration. In either case, it still prevents us from realizing the maximum loss on the spread if the underlying security continues to move down in price.

Adjustment 2: Buy to close the short leg, leave the long put open

In this adjustment we might realize a larger loss upfront as the cost to close the short put is not countered by selling to close the long put option. This adjustment is best used if the stock hits the mental stop in the first week or around the half-way point of the trade. By leaving the long put open we may see an increase in the put price if the stock continues to move against us. If PCLN declined below $595.00 by December expiration we would be able to close the long DEC 595 put for its intrinsic value, hopefully countering the initial loss taken for closing the short leg. This adjustment is not advisable if the stock hits the lower target in the last week of expiration as it is less likely to see the decline needed in the underlying stock to see increased value in the lower strike put.

What happens if the lower target is reached, we close the short leg and the stock recovers? This would present an opportunity to re-sell the short put if we still had time remaining to expiration. We may not be able to take the same or higher premium if we re-sell the DEC 600 put at a later date, but we still may be able to realize a positive credit on the position.

Adjustment 3: Roll down the spread

If our lower target is reached at any point we may attempt to roll both legs of the spread to a lower strike prices, either in the same expiration cycle or further out in time. To roll the spread we would close both legs as described in Adjustment 1, then we would look to open a new position such as:

Sell to Open DEC 590 put

Buy to Open DEC 585 put

If our lower target is hit in the first week or at the half-way point we may be able to keep the same expiration cycle and still achieve a credit. Using the theoretical losses discussed earlier we may have a loss of -$1.31 per contract if the initial spread was closed in the first 7 days and a loss of -$1.19 per contract at the half-way point. In order to remain profitable the new spread that we would open would have to have a net credit greater than $1.31 or $1.19, respectively. If we could not achieve a new net credit that is greater than our initial loss in the same expiration cycle we might consider opening a spread farther out in time, such as January 2013 or February 2013.

Rolling down the spread to lower strike prices may seem attractive but one must carefully evaluate the underlying security and current market conditions before simply rolling the spread. If the stock continues to decline in price you may have to roll the position again, and again, and again. Continually rolling down the spread can result in much larger losses than you initially anticipated if the security continues to move against your market sentiment. One could view this as the old cliché, ‘trying to catch a falling knife’. In some cases it may be best just to liquidate the spread and take the loss if your sentiment on the stock has changed.

These are just a few basic ideas on how to manage a vertical spread if the underlying security moves against your market sentiment. If the stock stagnates or stays within a tight range after the bull put spread has been placed, one might consider selling an out-of-the-money bear call credit spread to create an iron condor. If the stock moves up quickly after the initial bull put credit spread was placed, we may consider closing the position early for a profit. A good rule of thumb here is the 80/20 rule – if we can close the spread early and realize 80% of our potential maximum profit, it may be a good idea to take the money off the table now rather than risk a pull back in the stock.

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