Credit Spead Management --- Some Insights

A recent friend ask me a question about his call spreads. He seems to have the right attitude to deal with risk early on in position's life. One of his methods is to roll his credit spreads once the credit spread's value loss has reached   150% the initial value of his spread. 

The question posed are: how often will the adjustments be needed, and how early or late in the life of the position will the adjustment be needed.

Let us consider call spreads on NDX. The distance between the short strike option and the long strike option is 25. points, which represents around 11% of the NDX current value. The option are monthly or less. One starts with a monthly option. When the rolling is ongoing, the option might have less than one month to expire.


The call spread premium is around 1.25, which on a 25 points distance between strikes,  represents 5% of the width of the spread. We consider the 5% as a proxy of the probability of failure, if nothing is done to the credit spread until expiry (if one takes the worse-case loss). The probability that a trade gets beyond the short strike should  be around 10% ( It is the double of 5%). This might may not be intuitive at first, but there is a justification for it from theoretical standpoint.



The probability corresponding to a 150% loss should be higher than 10% (because one wantsthe stock to never get to your short strike). To get an approximation of the 150% loss prob, there are two ways. Here is a first way, which assumes one access to a PL curve of the credit spread as a function of stock price and time.

If your broker gives you a PL for the spread as a function of price and time, you should be able to find the price of the stock where you get the 150% loss on the spread.

Once you get that price, you then run a touch probability calculator. If you do not have it, here is rough approximation that gets the essence of the work.

You get the delta of the call of corresponding to the price of the stock where you will get the 150% loss, and multiple that by 2. That will give you the probability that the 150%  loss would  be reached.

Here is the insight: The probability that one gets the 150% loss is higher at the first day, then it decreases over time if the stock does not move, and of course if the stock moves in one's favor the probability of the 150% loss decreases.

What do we learn from this:  with directional spreads, one is at risk early on in the trade, and adjustment would happen early on in the life of the trade, and they should happen more frequently than one might have thought by looking at the 5% probability of loss if the position is held until expiry.

To your stock and option trading profits!