SPX Credit Spreads with downside collapse protection.

[Maji 203]

I attended a webinar based on an invite and saw a system of incorporating credit spreads including some protection in case of large moves to the downside. Basically, if there is a spike up in volatility due to a market meltdown, the system may even generate a modest profit or allow for exit with a small loss. The system is designed for the SPX but I will be testing it on SPY for a few weeks to see if I want to jump into SPX with it. Also, for the SPY, I won’t include the downside protection because the exposure will be small in absolute dollar terms and the commissions will be large compared to the cost of the protection. I am assuming everything is SPY will be 1/10 of SPX.

Here are the rules:

1.       If this is the first trade then determine if the SPX is in an uptrend or downtrend. Nothing fancy, just look at the chart and see. From what I see, the SPX is in an uptrend (There you go, I have called the top 😊).

2.       Sell a 20-point credit Spread on SPX (2 point for SPY). Sell put spread for bullish case, call spread for bearish case.

3.       Make sure you get at least a credit of 2.20 for SPX. The distance of the short strike will be determined here. Try to maximize it from current price but ensure that you get at least 2.20 credit for a 20-point spread. From empirical observations, it appears that these are about 75-80 deltas or something near there. Do not try to get too much more than this credit as it will move you to a closer strike than the system anticipated.

4.       Use options with expiration ideally around 35 days.

5.       The profit target is entire credit collected as the spread expires OTM.

6.       Stop Loss is when the debit to close the spread has increased to 6.00 (based on bid). That means the loss is 3.80 for the SPX.

7.       Place trades every two weeks. If the latest spread is making money then place trade in the same direction. If it is underwater, then place the trade in the opposite direction. If you exited the last trade due to a stop loss then you need to use some judgement. If you believe the market will move up, then sell a put spread, if not, then go with a call spread.

8.       For SPX put credit spreads, buy a long Put for 0.20 with 60-75 days to expiration. Basically, this is insurance and will expire worthless most of the times. However, during large spikes downwards, there is Vega inversion and these will help to mitigate the losses as the markets won’t honor the stop loss during those times.

According to the webinar presenter, the win rate was around 80%. Thus, expectation is 0.8*(2.2-0.2) – 0.2*3.80 = +0.84. If, I use 0.75 as the win rate, then expectation is +0.55. For options with the deltas mentioned in the rules, a 0.75 win rate appears reasonable.

For SPY, sometimes corresponding strikes may not be available. In some cases, the SPY options for the required dates have strikes with 2.50 separation. For practice purposes, I am thinking of locating the short at the SPX or near there and the long will be the nearest strike 2 or 2.5 away. For this example, it will be 257.5/255 instead of 2580/2560 for SPX. 

The purpose is to get a feel for the market. The transaction costs for the SPY will end up being higher than the SPX any way and can't be traded on a regular basis unless you have a free or a very low commission deal.

Maybe someone can back test the system and let me know. My Scottrade account recently got transferred to TDA and now I have access to TOS platform. I am not familiar with it but I was able to simulate the trade and then spiked up the volatility and it showed how the curve moved up with the increase in volatility allowing us to probably close the trade at breakeven or smaller loss in case of those large moves.

The screenshots for the PnL for two cases are shown below. The first one is with the volatility at the current level. In the second case, the volatility is bumped up by 35%. You can see that the magenta line moves up the zero line, showing that we may be able to liquidate the spread for a breakeven or maybe for a small loss. For normal down moves, the stop loss can be honored but for the catastrophic down moves, we need this kind of protection.

Also, if you have any comments please post here. I am not sure if I can answer all your questions but I am hoping to learn and add another system to our arsenal.

 

 

 

 

 

 

[CPO 37]

I would be interested to see what period this win rate applies to. In a bull market like we've had since 09 I can imagine this would be a winner. However, like all directional trades, the periods of chop are when this might perform poorly. Do you happen to know about the that @Maji?

[Maji 203]

@CPO I believe they had records for two years. Would like to see chop performance myself too.

[drcruz 116]

@Maji what is the capital requirement to keep 3 SPX trades on? If I'm thinking correctly the max number of trades on at once will be 3.

Also, I was fooling around with the TW platform and I was able to get your target credit around 20 deltas and not 80 deltas  (which would make the position ITM). 20 deltas would be OTM

Edited March 11, 2018 by drcruz

[Maji 203]

Each one is about 2000 minus 200 = 1800 dollars. You are correct, I meant 75-80 deltas away.

Edited March 11, 2018 by Maji

[scubaskeeter 6]

SPY at 276.80.  I chose April 18 at 37 day because the IV was slightly higher. So how do we add the protective puts? We need 'em cuz this is pretty close to the money for me. The 272 spread appears to fulfill the first part of your trade Maji. I used SPY because one can actually expect a fill at the prices used. 

[Maji 203]

@scubaskeeter The protective puts are really in case of crashes... they are basically cost of doing business. For SPX spreads, where each spread risk is $1800, a $20 insurance is cheap. For the sake of the system, a May 18, 120 Put for 0.02 will be the insurance.

Remember, this will not protect you from the normal stop loss being triggered, but will come into play if the market crashes and the market has gone through your stops. The elevated volatility will increase the cost of this put which will help to offset that loss. 

[CPO 37]

Does the protective put actually do anything in this setup? The PCS is limited risk and a market crash would quickly put the trade at that limit.  Adding a 0.20 put far OTM seems like an unnecessary complication with no real value.

 

[Maji 203]

@CPO... please take a look at the second image in my initial post. The purple line shows that the spread is making money even when the market is crashing as the IV has increased. Compare it with the first picture. The risk is around $1800 per spread and the reward is $200. So, in order to prevent those kind of large losses, the deep OTM put comes to use. Actually, the person who made the presentation showed his PnL curve during last February's mini market crash..

[drcruz 116]

Maji , Did the presenter explain why the trade was entered every 35 days?

Edited March 23, 2018 by drcruz

[drcruz 116]

I took the concept and sold a naked SPY 283 May 4 Call (42 DTE) collected about $28 credit (5 delta) w/ limit stop order @ $56. I figure markets don't crash up may be 10% chance of touching my strike. Poor ROC though ~$3100 in margin (2 positions >$6200). I'll sell one 2 weeks from now so every 2 weeks eventually one position will close and one will open.

 

Hopefully a little income generator while learning SO concepts

Edited March 23, 2018 by drcruz

[Maji 203]

On 3/22/2018 at 10:58 PM, drcruz said:

Maji , Did the presenter explain why the trade was entered every 35 days?

No he did not... I guess that is something he found out through backtesting... 

[Maji 203]

On 3/23/2018 at 11:56 AM, drcruz said:

I took the concept and sold a naked SPY 283 May 4 Call (42 DTE) collected about $28 credit (5 delta) w/ limit stop order @ $56. I figure markets don't crash up may be 10% chance of touching my strike. Poor ROC though ~$3100 in margin (2 positions >$6200). I'll sell one 2 weeks from now so every 2 weeks eventually one position will close and one will open.

 

Hopefully a little income generator while learning SO concepts

man... you are brave to take up those trades... 

[drcruz 116]

Yeah, I took the same amount of credit, I increased my probability of success, but the ROI is < 10%

[Yowster 7,996]

10 minutes ago, Maji said:

man... you are brave to take up those trades... 

agreed... These things are horrible from a risk vs reward perspective, on a big upward spike the trade can be a big loser (and be significantly above stop limit order).   While I agree big upward spike is less likely than a big downward one, this is the type of trade where one big loser can erase many, many winning ones.  

[tytch168 2]

On ‎09‎/‎03‎/‎2018 at 7:33 AM, Maji said:

I attended a webinar based on an invite and saw a system of incorporating credit spreads including some protection in case of large moves to the downside. Basically, if there is a spike up in volatility due to a market meltdown, the system may even generate a modest profit or allow for exit with a small loss. The system is designed for the SPX but I will be testing it on SPY for a few weeks to see if I want to jump into SPX with it. Also, for the SPY, I won’t include the downside protection because the exposure will be small in absolute dollar terms and the commissions will be large compared to the cost of the protection. I am assuming everything is SPY will be 1/10 of SPX.

Here are the rules:

1.       If this is the first trade then determine if the SPX is in an uptrend or downtrend. Nothing fancy, just look at the chart and see. From what I see, the SPX is in an uptrend (There you go, I have called the top 😊).

2.       Sell a 20-point credit Spread on SPX (2 point for SPY). Sell put spread for bullish case, call spread for bearish case.

3.       Make sure you get at least a credit of 2.20 for SPX. The distance of the short strike will be determined here. Try to maximize it from current price but ensure that you get at least 2.20 credit for a 20-point spread. From empirical observations, it appears that these are about 75-80 deltas or something near there. Do not try to get too much more than this credit as it will move you to a closer strike than the system anticipated.

4.       Use options with expiration ideally around 35 days.

5.       The profit target is entire credit collected as the spread expires OTM.

6.       Stop Loss is when the debit to close the spread has increased to 6.00 (based on bid). That means the loss is 3.80 for the SPX.

7.       Place trades every two weeks. If the latest spread is making money then place trade in the same direction. If it is underwater, then place the trade in the opposite direction. If you exited the last trade due to a stop loss then you need to use some judgement. If you believe the market will move up, then sell a put spread, if not, then go with a call spread.

8.       For SPX put credit spreads, buy a long Put for 0.20 with 60-75 days to expiration. Basically, this is insurance and will expire worthless most of the times. However, during large spikes downwards, there is Vega inversion and these will help to mitigate the losses as the markets won’t honor the stop loss during those times.

According to the webinar presenter, the win rate was around 80%. Thus, expectation is 0.8*(2.2-0.2) – 0.2*3.80 = +0.84. If, I use 0.75 as the win rate, then expectation is +0.55. For options with the deltas mentioned in the rules, a 0.75 win rate appears reasonable.

For SPY, sometimes corresponding strikes may not be available. In some cases, the SPY options for the required dates have strikes with 2.50 separation. For practice purposes, I am thinking of locating the short at the SPX or near there and the long will be the nearest strike 2 or 2.5 away. For this example, it will be 257.5/255 instead of 2580/2560 for SPX. 

The purpose is to get a feel for the market. The transaction costs for the SPY will end up being higher than the SPX any way and can't be traded on a regular basis unless you have a free or a very low commission deal.

Maybe someone can back test the system and let me know. My Scottrade account recently got transferred to TDA and now I have access to TOS platform. I am not familiar with it but I was able to simulate the trade and then spiked up the volatility and it showed how the curve moved up with the increase in volatility allowing us to probably close the trade at breakeven or smaller loss in case of those large moves.

The screenshots for the PnL for two cases are shown below. The first one is with the volatility at the current level. In the second case, the volatility is bumped up by 35%. You can see that the magenta line moves up the zero line, showing that we may be able to liquidate the spread for a breakeven or maybe for a small loss. For normal down moves, the stop loss can be honored but for the catastrophic down moves, we need this kind of protection.

Also, if you have any comments please post here. I am not sure if I can answer all your questions but I am hoping to learn and add another system to our arsenal.

 

 

 

 

 

 

Hi Maji, how's your latest testing result on SPY for this strategy?

[Maji 203]

7 hours ago, tytch168 said:

Hi Maji, how's your latest testing result on SPY for this strategy?

I never put real money to test it. The stop losses can get triggered more frequently than the deltas suggest during gyrations we are seeing currently.