Adjusting Credit Spreads

A subscriber asked the following question regarding adjusting credit spreads that become threatened by an approaching underlying:

"....If a short position is approaching ITM, when do you “manage” the position to either buy it back at a loss, roll it to a higher value, or roll it to another month? I have read several opinions on this topic. Some say when the price comes within 2% of the short price. Others say when the probability goes below 60% and still others say that the price must break the 50 (or 21) day SMA. What criteria do you use to make this decision?"

There is unfortunately not a perfect answer. While some have steadfast rules like mentioned, MA's, percentages, probabilities, etc., I think it is more important to treat each trade individually. Don't get me wrong, I am all for trading rules and have many of my own, but rules are to be guideposts, not brick walls.

Take for instance the SPY put spread we had in March that went underwater when the Japanese tsunami/nuclear events took place. The market swooshed lower but we did not close the trade. Instead, we adjusted the trade out a few weeks and up one strike. Our analysis indicated the market was oversold so we rolled out and up to allow the trade to recover. As a result, we turned what could/would have been a 50-70% loss into a marginal 15% loss; in fact, in keeping with proper risk management, we closed the spread a few days prior to OpEx but it ultimately would have expired worthless (hindsight is always 20/20). Keeping it open though would have been gambling because the underlying was too close to the short put so we used our trading rule “guidepost” to close.

Conversely, we have a IWM spread open right now that some subscribers have inquired with heartburn over as the IWM has rallied hard and strong recently. IWM reached all time highs and kept on trucking getting within 1.5 points of our short call. However, in IWM's case, even though the market appeared strong and the “guideposts” said to potentially adjust, our analysis reflected otherwise and we now have a nice margin of safety going into OpEx as the WM has backed off.

In summary, you have to have a trading plan but also must be flexible as each trading day is a new day and things are not the same as they were yesterday. I know this isn't the precise answer many search for but hopefully it provides some insight into how to approach open trades.

Stay tuned and happy trading everyone.

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