How do credit spreads work

Examining a Volatility Spike

The reality is, sometimes volatility only appears to rise. The rise in volatility visible in the implied volatility indicator of a typical price chart (or in a volatility index such as the VIX) can be more the result of price moving down thru lower strike prices with higher IV’s than it is any substantial change in the volatility surface, itself.

In the image above, take a look at how the implied volatility of the at-the-money (ATM) strike rises from about 38% to 44% when price drops from 730 to 690. Notice that while the volatility skew has not changed a wink, the ATM IV value has increased by almost 16%.

Ignore for a second the oversimplification of the example. What I want to point out is what happens to the out-of-the-money (OTM) volatility. For the sake of discussion, let’s say that when price was at $730, the 620 strike was the 15 delta put and at a 50% IV, our analysis indicated it was extremely expensive (for more on this analysis, sign up for the Advanced Vertical Spread course available soon). If one had sold the 610/620 put spread at that time, the drop in price down to 690 obviously means trouble.

However, notice that the implied volatility of the 620 put has not changed with the price drop. This is an enormous benefit to the position. Because the trader sold the credit spread into an extreme skew, the skew itself lends a hand in managing the trade.

The Three Dimensions of Vertical Spreads

The trader who sells out-of-the-money credit spreads anticipates one or three of the following to happen:

    Price will rise or remain neutral Time will decay Volatility will decrease

These are the three dimensions of credit spreads (we’ll talk about how gamma fits in another time). So with price dropping and volatility rising, the 610/620 put spread should be taking a two dimensional beating. But instead, the IV of the short put is unchanged.

Selective Trade Entries based on Skew

This type of phenomenon can only happen when a trader initiates a credit spread (or Iron Condor) when OTM volatility is elevated. With these IV’s high, the options market has already priced in a

drop in the underlying. If the underlying does indeed drop, it is not accompanied with an enormous wave of put buying since the move was anticipated. The opposite is true when OTM IV’s are low. In that case, a drop in the underlying results in a mad scramble of panic buying in the OTM puts, driving their IV’s to elevated levels.

A selective entry using skew provides a clear line of defense when the original thesis for the trade falls apart. By selling into extenuated skew, the trader is actually beginning the smart management of a position (at no cost, mind you) before any adverse action has even begun.

Changes in Skew

The example above is purposefully oversimplified to illustrate a point. In reality, the curvature of the skew will change and the change can be dramatic. Large price moves against a credit spread will see gamma risk explode and the vega sensitivity heighten (depending on the width of the spread). There is no doubt the trade in this example needs additional management. However, these principles remain true:

    Price dropping thru more expensive strike prices can create an exaggeration in ATM volatility Highly bid OTM puts remain relatively stable during a price drop. Selling overpriced options provides a defensive (as well as offensive) edge to the trade.

Advanced Vertical Spread Course

I will be teaching a live series of courses soon that for lack of a better name, I’ve so far dubbed the Advanced Vertical Spread Course. Though the focus will be on “Credit Spreads,” it will be with a flexible interpretation of the term. We will focus on constructing spreads that have a similar high probability risk/ reward structure to credit spreads, but are executed with the maximum edge thru the analysis of options order flow and the volatility surface. We will also spend some time discussing position management, including insurance and adjustment strategies. The course will begin at a level that everyone understands and move forward from there, with the availability of question and answer sessions in between. This first course will be offered at a minimum cost and will include a semi-daily trade ideas using the information we discuss. To be notified when this is available, send an email to .


Category: Credit

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