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Credit Spread Adjustments: Delta Hedging with Stock

One of the most effective ways to adjust a broken out-of-the-money vertical spread is with stock.  So many of us in the retail world—having been introduced to the flexibility and/ or leverage of options—seem hotly opposed to taking a position in an underlying stock, ETF or future.  Many of us would rather torment a simple vertical spread with layer upon layer of complicated adjustments, so that what started out as a hands-off strategy becomes a position that must be constantly tweaked—the original thesis for the trade reduced to a footnote.

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The Risk Free Spread. Yes, You Read That Right.

I’m not usually one for sensationalism.  So okay... “risk free” is a matter of interpretation.  This is a very simple trade and we’ll use MDR as an example since everyone and their mother (including me) tweeted about it when bullish order flow hit the options market.  Essentially what I’m talking about here is converting and at-the-money vertical spread into a Butterfly.  This type of trade can be done no matter what the entry, but it works best when the initial trade is a close-to-the-money credit or debit spread.

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Trading Vertical Spreads as Unbalanced Condors

Over the last month and half, technical signals have proven to be false or extremely short lived.  So how do you trade the traditional, conservatively positioned vertical spread when the broad market indices are in a craze?

The first question you have to ask yourself is, “Does it makes sense to be trading these positions at all right now?”  The truth is, while the Option Workshop focuses on vertical spreads, the trade makes more sense in some environments than others.

But right now is in fact, a good time for verticals.  Since implied volatility is high (both in the at-the-money and out-of-the-money strikes), vertical spreads can generally be positioned at top dollar and/ or further away from price than normal.  On the other hand, volatility is high for a reason – price is moving around a lot.  A trade positioned well out-of-the-money today, may find itself at-the-money three days from now.

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Vertical Spread Open Position Management

The three components of managing a Vertical Spread are:   1) a profit target, 2) a stop loss and 3) an adjustment point.  Perhaps the easiest one to start with is the profit target.  But first… some background:

Time Decay

The vertical spread system that we’ve talked about so far profits primarily from time decay and secondarily from directional movement.  Every option trader has at one time or another encountered the typical time decay graph, showing the escalation of decay during the final weeks of an option’s life:

A common misconception is that this graph represents all options, when in fact this is true only for at-the-money (ATM) options.  

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