How to adjust a credit spread

how to adjust a credit spread

Below is an example of how to make adjustments and/or hedge a bull put credit spread placed on the Brazil ETF, EWZ. The MCTO advisory service primarily focuses on credit spreads and iron condors on the Russell 2000 index - RUT, and the S&P 500 index - SPX and SPY, so we don't know much about the EWZ. One of our subscribers asked us to look at this trade so we decided to include our response in the Learning Center because making adjustments on options or creating a hedge on options like the ones shown below are applicable to just about any credit spread.

Below is the chart of EWZ, an ETF that comprises dozens of large and mostly Brazilian companies. Because this is an ETF that we don't trade, we don't know a lot about the fundamentals and underlying health of the Brazilian economy. If we did monitor the macro-economic data for the Brazilian economy, like we do with the US economy, we would have a higher probability of properly predicting if certain support levels will hold during a pull-back, such as the 200 day simple moving average (SMA) (thick black dotted line). With this said, however, we're still making a prediction and predictions can be wrong, especially when a market is temporarily driven by an abundance of fear or greed. Purely based on technical analysis by looking at the chart, we show three possible support levels of 63, 57 and 48. Based on these three potential support levels we model four scenarios below that each require a different type of adjustment.

Below is the weekly chart giving us a big-picture view of the EWZ and our predicted support levels.

Below is the original Qty. 10 bull put credit spreads that were opened on 1/19/10 for a credit of 9 cents, or $90. Required maintenance is $2,000, and total risk capital is $2,000 - $90 = $1,910.

Below is the same risk/reward graph shown above, but zoomed in a little.

Below is what the Feb 61/63 bull put credit spread looks like on 1/29/10 where the EWZ has pulled back to 65, putting the short 63 Put under pressure.

Scenario #1 - We predict that the EWZ will find support at its 200 day SMA near 63, stabilize and then gradually trend upward from this point on. This is based on the premise that the global economy is now recovering and Brazil will not have a double dip recession, so once the this sell-off is over the worldwide markets, and Brazil, will stabilize and then start to trend upward again.

For this situation, and because the last day of trade shown on the EWZ chart was a solid red distribution day on-higher-volume candlestick, it tells us that there is a good chance that this index will pull back to at least its 200 day SMA near 63. Thus, we should close out the Feb 61/63 bull put spread to reduce our downside exposure. Because this scenario predicts that the EWZ will find support at the 200 day line, we would roll-out our spread to the next month and down a little, where we execute a 4 legged order to close the Feb 61/63 bull put spread, and open the Mar 59/61 bull put spread. If your broker doesn't allow you to place a 4 legged order (i.e. 4 legs in a single transaction) and keep all of your original maintenance "in play", in this case $2000, we recommend for you to change brokers.

The math goes as follows:

Opened initial Qty. 10 Feb 61/63 bull put spread for a credit of 9 cents, or $90. (.22-.13)

In a single transaction comprising 4 legs we do the following:

Close 10 Feb 61/63 bull put spread for a debit of 59 cents (1.62-1.03)

Open 10 Mar 59/61 bull put spread for a credit of 55 cents (2.26-1.71)

Net price of the 4 legged transaction was a 0.09-0.59+0.55= credit 0.05, or $50.

That is, we rolled-out the Feb spread to a new March spread that is a little farther away from the underlying, we brought in 5 cents credit, and our new trade will expire in 49 days giving the underlying index a chance to bottom out and to start recovering. If the EWZ is above 61 at expiration we will keep the $50 and we actually made a little bit of money. As a note, we are only feeling comfortable to roll-out to the next month since the global economy is now recovering. If we were still in a bear market where the underlying macro-economic data are showing that the US and other leading economies are still contracting, we would not be recommending to roll-out into the following month.

Below is what the new trade looks like.

Scenario #2 - We predict that the EWZ will find support at its June high and Aug low near 57, stabilize and then gradually trend upward from this point. This scenario is based on the premise that

the global economy, and Brazil, is now recovering and there will be no double dip recession, so once the this sell-off is over the worldwide markets will stabilize and then start to trend upward again.

Below is the original Feb 61/63 bull put spread as it looked when it was first opened on 1/19/10.

Below is what the Feb 61/63 bull put credit spread looked like on 1/29/10 where the EWZ pulled back to 65, putting the short 63 Put under pressure.

For this situation we do the same as we did above, by rolling-out our Feb bull put spread into March, but this time, unfortunately, we bring in less of a credit since we are rolling into a spread with lower strike prices. In order to make this work where we'll at least break even, we'll need to open more of the new March spread. The math goes as follows:

Opened initial Qty. 10 Feb 61/63 bull put spread for a credit of 9 cents, or $90. (.22-.13)

In a single transaction comprising 4 legs we do the following:

Close 10 Feb 61/63 bull put spread for a debit of 59 cents (1.62-1.03)

Open 17 Mar 54/56 bull put spread for a credit of 30 cents (1.09-0.79)

Net price of the 4 legged transaction was .01, or $10. (we have to take into account that we initially had qty 10 of our spreads, and the new March spread is qty 17)

Overall, we'll break even the underlying EWZ closes above 56 in 49 days.

Scenario #3 - We predict that the EWZ will continue to drop down through the 200 day SMA and find support at 48, its May and July low, stabilize and then gradually trend upward from this point on. This scenario is based on the premise that Brazil's recovery is not as robust as some of the other leading economies, and that its macro-economic outlook is weak. This is hypothetical in nature as we have not done the economic analysis of Brazil. With this said, we then need to make the decision to either hold onto the original Feb 61/63 spread, or close it out.

Below is what the Feb 61/63 bull put credit spread looked like on 1/29/10 where the EWZ pulled back to 65, putting the short 63 Put under pressure.

One option is to buy a protective EWZ March 63 Put, as shown below, in the ratio of 1 Put per 10 credit spreads, at the cost of $206, and keep the original Feb 61/63 spread open. Assuming the the underlying index continues to drop and stays between 50 and 60, we can see that time works against us so the longer that we hold this trade the more we lose. On the other hand, if the the EWZ stays above 63, the longer we hold it the more we make.

The other option is to buy a protective EWZ March 63 Put, as shown below, in the ratio of 1 Put per 10 credit spreads, and to close out the original Feb 61/63 spread. We can see that when first making this adjustment it costs a debit of $796 to close out the original spread and to buy the protective Put. If/when the EWZ pulls back to 56, however, we've broken even on the trade and if we wish we can close out the trade and walk away unscathed.

Scenario #4 - We predict that the EWZ will find support at its 200 day SMA near 63 and then trade sideways and choppy for a few months. This scenario is based on the premise that Brazil's economic rebound is stagnating. Again, this is only hypothetical as we have not done the analysis on Brazil's economy.

Below is what the Feb 61/63 bull put credit spread looked like on 1/29/10 where the EWZ pulled back to 65, putting the short 63 Put under pressure.

Below we open the Feb 60/63/69 butterfly, and the above risk/reward graph transforms into the graph shown below. The legs in light blue make up the original 61/63 bull put spread. The legs in orange make up the butterfly.

We then open 2 Mar 74 calls, and 2 Mar 55 calls to bend both the top lines and bottom lines inward. We reduced total required maintenance to $1756, and if the EWZ expires between 62 and 67 we make some good money, at a maximum of $1500 if the index closes at 63 on the day of expiration, which of course has a very low probability of happening. Light blue represents the original 61/63 spread; orange is the butterfly; and green are the two far out-of-the-money (OTM) calls and puts to bend the lines inward. As you can see this trade is getting rather complicated and one will need access to an options analysis package in order to play with the different legs to achieve a desired shape of graph.

Source: www.monthlycashthruoptions.com

Category: Credit

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