Q and A. Comparing Spread Risk


I thought I would share a sort of activity in which I was engaging for a while (but find no opportunities of late). I have seen related discussions recently in online forums.

The basic idea is that given an equity one finds quite attractive at a price only somewhat below its current price, one can sell naked puts to reach that attractive price goal. [MDW note: Yes, if assigned an exercise notice]

The added twist in which I had been engaged was to risk the same amount of capital in a single strike separation bull put spread [MDW Note:  sell a 45/50 put spread, for example] (or perhaps some other width, depending on the numbers).

A rapid collapse through through the short strike would make me uncomfortable about the possible losses, but allow for the sale of most of the long puts and purchase of all short puts (under those market conditions, providing some profitability to the downside ).

Now the absolute amount at risk has not been reduced, but the rate of loss most certainly has. The goal of acquiring stock at or near the strike price is nearly achieved.

As it happens, I did not have any outsized gains from this activity,nor did I acquire any stock. The consolation prize (outsize gains being the goal) was collected in each case when the market bounced and sudden euphoria set in.

I am now trading ICs in some markets. I am starting to feel uncomfortable about this — just on an instinctual/gut/superstitious level (yes, I have more on in index ICs).  My concern is all the short vega.


Thanks for sharing.

There is a fallacy embedded within your idea. Although the stock can fall to zero, it's extremely unlikely.  As a result, the maximum theoretical loss when writing the naked put is almost never realized.

On the other hand, it's much more common for the stock to move through both strikes of a put spread, resulting in (assuming  no adjustments) the maximum theoretical loss. Thus, the reason an 'equivalent amount of capital at risk' is not the correct way to equalize risk.  The probability of incurring that loss must be considered.

If you are considering selling 5 Aug 60 puts @ $3.00, the potential loss can approach $30,000 (Buy 500 shares @60, stock goes to a low price near zero, minus $1,500 premium collected), but in reality, that potential loss is less. There's always time to get out at some price to salvage a portion of your investment.

Compare that play with selling 60 Aug 55/60 put spreads @ $1. The maximum loss for 60 such spreads is $30,000 – less the $6,000 premium collected. Of course, you can use that premium to sell even more spreads, but let's ignore that possibility for this discussion.

Which of these positions is more likely to earn a profit?
Which can earn the higher profit?
Which is more likely to incur a significant loss?

To earn a profit,the stock must not be much lower than 60 when expiration arrives.  For the naked put trade, the break even point is $57, and it's $59 for the put spread sale.  Thus the naked put has a better chance to earn a profit.

But there's $6,000 potential profit when selling the spread compared with one fourth that amount for the naked put sale.  That makes the spread look attractive.

But that attractiveness disappears when you consider potential losses.  If the stock moves to the low 50s at expiration, the naked put seller loses approximately $4,000 less premium, or $2,500.

The put seller loses the maximum, or $5 per spread (less $1 premium).  That's $24,000.

These positions can hardly be considered to have the same risk.  And that's the fallacy in the argument of 'I'll risk the same amount of capital.'

One point I stress in The Rookie's Guide to Options is that the real danger of selling put credit spreads is being unaware of just how much money can be lost.  That encourages many option traders to sell far more spreads than justified.  'Size kills' is an appropriate expression used by investors who understand risk.  You cannot afford to be greedy by taking more risk than your experience and pocketbook can handle.

Regarding the iron condors:  Although short put spreads have risk associated with short vega, it's only half as much as the iron condor.  If negative vega is uncomfortable, consider combining double diagonal spreads with iron condors.  Another reasonable decision is to avoid iron condors and use strategies that are nearer to vega neutral.

Late ADDENDUM: Those profits of which you write that you collect on the downside are a figment of your imagination.  there are no profits.  Only losses.  If you are considering selling all your longs and covering just a few of your short puts, that is a huge gamble.

Please rethink this.


14 Responses to Q and A. Comparing Spread Risk

  1. kbluck 04/27/2009 at 10:30 AM #

    As you point out here, the main reason so many think that options are “too risky” is because they are conflating margin risk with option risk. Selling naked puts isn’t risky as such; selling the maximum quantity of naked puts your broker’s margin rules will allow, well beyond the amount of stock you could afford to buy if assigned, now *that’s* risky. But the poor naked put gets blamed when the real sin is overtrading.
    If only more IRA trustees would allow naked puts. That’s got to be the best possible place to start trading them, since the cash-secured rules make it far more difficult to overtrade. It’s especially exasperating when the same IRA trustee that says cash-secured naked puts are too risky to allow *do* allow vertical put spreads as you describe here, which offer the capability to completely zero out a lifetime of savings with a single trade.

  2. kbluck 04/27/2009 at 10:34 AM #

    Re IC vega: I’ve been toying with the idea of neutralizing vega using long calls on the underlying volatility index; for a RUT IC, for example, I would buy OTM RVX calls with deltas equal to the short RUT vega. Any comments?

  3. Mark Wolfinger 04/27/2009 at 11:35 AM #

    The amazing part to me is that they allow customers to buy stock when unhedged (naked long) – a prudent investment by everyone’s guidlines. Yet writing a cash-secured put is less risky because the maximum loss is less than that of the stockholder. But that’s not universally allowed.
    Brokers who prohibit such IRA trades are either doing whatever they can to steer custimers away from options, or else are truly ignorant.
    Og course I agree that ‘options’ are not risky – it’s the person who adopts risky strategies who converts options from risk-reducing tools into a gambling mechanism. And somtimes it’s so easy to fall into the trap of taking too much risk – because of blind spots. And overselling put spreads is one of those potential blind spots.

  4. Mark Wolfinger 04/27/2009 at 11:42 AM #

    Yes. Be careful.
    I’ve never traded these VIX or RVX options because the underlying asset is a futures contract, and not the cash value of the index.
    Thus, this is a very poor hedge. For example, when exercising the recently expired April VIX options, you get a positoo in the JUNE futures. We have seen many occasions in which the front month VIX or RVX exploded higher, but the futures in later months lagged by a significant amount.
    The point is: the correlation you seek is just not there.
    I pefer (and that does not mean that you will prefer it) to buy vega when I believe I have too much short vega. I do that by buying front-month strangles. That also gives me some gamma protection.
    But buying calendar spreads or double diagonals also takes a bite out of vega risk.

  5. kbluck 04/27/2009 at 12:11 PM #

    Excellent points. The futures factoring in mean reversion and thus not tracking the spot is a real problem with this idea.

  6. kbluck 04/27/2009 at 3:06 PM #

    I just looked at CBOE and both VIX and RVX are European cash-settled based on an SOQ of the actual volatility index.
    If they are not based on futures underlyings after all, does that change your view much about their correlation?
    I’ll have to do some back-testing to see how well they would have hedged against some of my past positions’ vega. I sort of wonder if it wouldn’t also offer some de facto gamma protection on the assumption that fast market moves will be accompanied by volatility spikes. I guess this will be my little research project during slow markets.

  7. Mark Wolfinger 04/27/2009 at 5:11 PM #

    No, it does not change my view.
    The truth is that I have not paid attention to these options once I discovered that they do not trade in a manner that would do me any good. And if I understand your planned use correctly, they will not help you either.
    I don’t understand why they made these options European style, but that’s ok. It’s just one more product I don’t trade.
    I also know that countless individual investors buy and sell these options withough the slighest idea as to what they are trading.
    When you buy RVX call options and then see RVX spike, you will disocver that these options are trading as if RVX were much lower than 100. You will find call options trading many points below parity. Thus, your option portfolio is not hedged. The bottom line is that these options will not increase in value by enough to offset the losses from your negative vega positions. You will have no idea how many of them you must purchase to get that hedge.
    These options will NOT have volatility spikes when VIX or RVX spikes. Why? Because the undrlying asset is NOT the current RVX. It’s the RVX on expiration morning. That many not be a ‘futures contract’ but it’s sessentially the same thing – as far as a trader of these options is concerned.
    If you want to learn more about VIX options, I suggest reading Billy Luby’s blog: http://vixandmore.blogspot.com/

  8. kbluck 04/27/2009 at 5:38 PM #

    I see your point. Even synthetics don’t work right. Looking back to 11/21/08, when the RVX closed at about 80, doing a synthetic short -Dec80C/+Dec80P carried a debit of 9 points. It seems curious to me, as I would think that your ‘its the RVX on expiration day’ comment would apply equally well to any Euro index option like, say, RUT. I guess it illustrates just how strong is the expectation of mean reversion for volatility.
    On a side note, I just noticed the ‘binary’ options on SPX and VIX. I guess those let you trade pure market direction without regard to volatility? Ugh. I’d better quit for the day before I sprain my brain.
    Thanks for the link; that looks like a really interesting blog. And thanks for taking the time to entertain my wild ideas. You’re a very patient man.

  9. Mark Wolfinger 04/27/2009 at 9:35 PM #

    It cannot apply to RUT. Why? Because you have the ‘real’ underlying to hedge. If you were able to buy the risk reversal (long call, short put) significantly under parity, you could then short the futures as a hedge.
    RUT has no such underlying. There is no cash VIX index to sell. The best one can do is sell the ‘futures-like’ contract that expires on a specific date. That’s simply not a good hedge.
    Mean reversion is much more likley to occur in an index that measures volatilities than an index that measures stock prices.
    Thanks. Almost no one I know thinks I’m patient!!!

  10. Jim Lindor 04/27/2009 at 9:51 PM #

    Hi Mark,
    I signed up for Twitter in order to follow your comments. I’m finding that almost all your tweets are meant for specific individuals. I find it kind of strange and am not sure if there is any point in my following what appears to be answers to questions when I don’t know what the questions are.

  11. Mark Wolfinger 04/27/2009 at 10:00 PM #

    A valid point that I never considered. And I’ll make an effort to fix that – it’s only fair to loyal readers like you.
    With Twitter, someone can direct a question to another. And the only way for the sender and recipient know that the othr sees the message is to direct it.
    I’ll see what I can do do clear this up. Perhaps re-post all questions on the blog.
    Right now, I don’t have a lot to tweet. I’m bdding to get out of some far out of the money Jun put spreads and decided to skip the July trade because I have enough positions (and risk) for the moment

  12. JCVictory 04/28/2009 at 7:35 PM #

    I think if you click on the name of the person being replied to on Mark’s Twitter, (i.e. @jcvictory) that will take you to that person’s account and their original question (asked with an @MarkWolfinger) . . . if that helps at all.

  13. Mark Wolfinger 05/05/2009 at 11:07 AM #

    I’m doing my best to reply to the tweet and answer in a way that makes the reply an independent message.
    In other words, there’s no need to know the question because the reply incorporates it.
    I truly hope this helps.

  14. i960 11/12/2014 at 1:20 AM #

    It’s probably not fair to directly compare a 6000$ premium spread play against a 1500$ premium naked call play. The former has much more “real” risk compared to the latter (ignoring it’s theoretically massive risk) just due to the higher premium received.

    To make a fair comparison one would need to balance amount of risk vs reward around opex:

    Equalized reward:

    5 Aug 60 puts @ $3.00, 1500$ premium, 3000$ loss @ 54.
    15 Aug 55/60 put spreads @ $1, 1500$ premium, 7500$ loss @ 0-54.

    Equalized risk:

    5 Aug 60 puts @ $3.00, 1500$ premium, 6000$ loss @ 48.
    12 Aug 55/60 put spreads @ $1, 1200$ premium, 6000$ loss @ 0-54.

    The puts B/E at 57 and start losing more than 7500 at anything <= 48.
    The spreads B/E at 59 but will never lose more than 7500 at anything <= 55.

    Obviously the spread takes on more "real" risk for the same level of reward – and perhaps that is in a way reaffirming what you're trying to say, I just think it's best to use similar figures of contracts for both.

    Of course the elephant in the room is that the naked puts can get much, much worse if something catastrophic happens (like 25000$ loss @ 10). For the real world case they are affording more breathing room than the spreads for the same level of strike risk and that means less overall risk (as long as it stays above 48). They have the added bonus of starting to pick up loss later as compared to the spreads (57 vs 59) due to the higher net premium received in the naked case.

    One thing to note though is that while widening the strikes in the spread makes it become more and more like a naked put – it'll never be the same due to having to pay for the outer put. Even widening it to 10$ or 20$ width is actually a worse reward vs risk than a narrow spread. While the narrow spread will have less absolute reward for the same amount of contracts one can always sell more of these narrow spreads to bring the reward back up but have a better reward vs risk ratio. It's not nearly the same when using a wider spread as the percentage of reward vs risk just drops as the strikes are widened (which is counter intuitive at first). However, there's probably more to it as the relationship of wide vs narrow spreads is directly related to how far OTM the spread is, volatility, puts vs calls, etc.