Loading…

Losing Trade Scenario Analysis and Short Vertical Hedging

scenario analysisIt’s great to talk about winning trades, but we can usually learn more from our losing trades.  A little time has passed since August 24th and I want to talk about my biggest losing trade of the year.  The trade was intended to be an unbalanced Iron Condor in the RUT.  I began the process of legging into the spread on August 18th, a little less than a week before the late August mini-crash.  I know, I have amazing market timing.

The trade began when I sold the $RUT 1000/980 Dec. 15 Put Vertical for 1.30.  The short put was around 9 delta at entry so the trade was relatively high probability.  At the time of entry, I didn’t choose to hedge the position.  I rolled the spread down a few days later and increased my size.  After that, Monday happened and I just got out because I was above my maximum intended loss for the position.

The image below shows the filled orders for the trade:

RUTcreditspread

The speed of the sell off is what created a problem for the short vertical.  As a result, I decided to take a look at a few different hedging options.  The hedges I considered were buying a roughly 5 delta put, buying a single ratio spread, and buying two ratio spreads.  The ratios were constructed as being long two puts around a 4-5 delta and short the 9 or 10 delta to finance the longs.  My goal was to have essentially zero cost insurance.  I also looked at the impact of purchasing the hedge when the trade was initiated on August 18th and on the day I rolled down, August 21st.

The table below summarizes the pricing for a few different options and the position itself.  As you can see, the 5 delta put costs around .47, which is expensive relative to the 1.30 credit for the short vertical.
CashFlowHedges

In the next table I summarized a few different scenarios.  We’re looking at the P/L for the position by date as well as the Delta of the short strike.  As you can see, I rolled the credit spread and doubled my size when the short Delta doubled.  The open profit on the hedges is provided at the bottom of the table.  Note that the ratios exploded in value especially when considered relative to their initial cost.

VerticalSpreadAnalysis

At this point, you have the background for a few different options.  The real question we want to answer is what would have been a better way to trade the position.

In the table below, I walk through four scenarios with the different hedges.  In the first scenario I consider what would have happened if I had stayed in the original position with the hedge and not rolled on August 21st.  The second scenario considers what would have happened if I had rolled on August 21st and kept my original hedge.  The third scenario looks at the position if I had rolled both my position and hedge on August 21st.  Finally, the fourth scenario considers what would have happened if I had stayed in my original position without rolling and purchased a hedge on Friday, August 21st when my short Delta doubled.

VerticalSpreadHedgeScenarioAnalysis

Lessons:

The tables above contain quite a bit of information to digest.  The biggest take away for me is that most of the outcomes above show a loss.  In other words, you are likely to lose money if the market trades strongly against your credit spread.  That realization makes controlling the loss extremely important.  Some people chose to “ride out” the pain in their open positions and that worked this time, but what if the market had continued lower?  High risk trading is something I’m not comfortable with in my own accounts.

Another big take away from the table above is that buying insurance late is not very helpful.  On August 21st, the market had already declined a good amount and out of the money puts were relatively expensive.  At that point it would have been better to close the position rather than buy insurance.

My preferred scenario above is to have purchased insurance and stayed in the trade without rolling.  That outcome shows a loss, but seems the most like something I would actually do in live trading.  We have no way of predicting major declines in the market and sometimes we wait and hope trades will work themselves out.  Sometimes that works and sometimes it doesn’t.

One of the reasons I’m not a big fan of the ratio spreads is that they introduce additional risks into the equation.  Specifically, the ratio spreads above generally worked out because price moved so quickly after entry.  However, in cases where that doesn’t happen, a ratio will tend to have a sagging T+Zero line and lose money on a mild decline.  You can also see that buying a ratio spread after implied volatility expands is not very helpful.

Risk:

We (as in options traders AND human beings) have a tendency to underestimate risk.  Options income trading has the potential create a false sense of security when we’re on a long winning streak.  All winning streaks come to an end and it’s important to manage risk in positions so that we aren’t destroyed when they do end.

I took a loss that was reasonable within the context of my winning months, but not reasonable within the context of my credit spreads.  I should have simply exited rather than rolling.  As my results for the year show, the bulk of my returns have come from Butterflies rather than Credit Spreads or Iron Condors.  However, the reason for the less than stellar Credit Spread returns has more to do with my own psychology rather than the trades themselves.

What do you think?  How would you have traded the position and why?  Let me know if the comments below and thanks for reading . . .

 

 

 

  • Very interesting analysis Dan. Experienced traders know that nothing teaches you more than losing trades. The bigger the loss, the more you learn.

    Sometimes the best adjustment strategy is to do nothing at all. None of my positions I placed prior to the August crash would have been in the money. It would have taken a lot of courage to hold those positions though.

    I think the bottom line is that it will be difficult to make money on spreads when the market makes a gigantic move up or down in such a short amount of time. Credit spreads performed the best in relatively mild markets like what we saw in the first 7 months of this year. They are less reliable if we have wild swings like what we are seeing now.

    As you pointed out, there is no perfect hedge and that is why strike selection and time to expiration is so important. It allows us to stay one step ahead of a fast moving market. One thing that has worked for me is going out further in time and distance. I also like to hedge with debit spreads when my short strikes have a delta of 20. This enables me to stay in a trade longer and provides some peace of mind while I decide the next course of action. I also will close the position if the delta hits 30 and redeploy a new spread or iron condor to recoup the losses.

    The large unexpected move is always a possibility but we have to use risk management to ensure that it does not blow up our entire account.

    • I really like the way you trade credit spreads and iron condors because they’re so low gamma. The duration of your trades seems long, but you’re never in the positions to expiration and you tend to experience much less heat.

      One of the bigger lessons I took away from the trade is that I’m just not crazy about the credit spread strategy in general. When a trade doesn’t fit with what you want out of a position it becomes very difficult to trade well.

      Ultimately, I think we either find something that works reasonably well for our psychology or we endlessly pursue the perfect trade. Realistically, there is no perfect trade so it’s something of a fools errand.

      I like the way you traded the same move and agree that you need to control your losses with credit spreads. Betting on the market reversing after a big move works . . . until it doesn’t.

      • It is very true. You need to find a trading strategy that works with you. I have bounced from strategy to strategy until I settled with credit spreads. I understand why some people do not like this strategy and that is fine. Every strategy has pros and cons.

        It’s simply impossible to predict what strategies will do best in the future and hopping around from strategy to strategy, will constantly guarantee you are curve fitting your portfolio to past results with little chance of future success. All trading strategies have risks with rewards and it is up to the individual investor to decide whether a given strategy meets their risk/reward requirements and trading style.

        Traders don’t go broke because they have a bad strategy, or they have no edge, or whatever. They go broke because they can’t manage risk or don’t have the ability to. Honestly you can blow up your account trading anything, stocks, bonds, options, futures, forex, etc… It is never the strategy it is always the risk management.

  • Navar Inversiones

    Nice analisys. Do you think to use synthetic position using 100 Deltas to hedge it?

    • Thanks! At the time, I didn’t plan on hedging it at all partially because I didn’t think the market would continue. As a result, I decided to roll and then take the loss if necessary. As we know now, it became necessary to take the loss.

      You’re right, I could also have sold shares of IWM or created a synthetic short with options. I’d need to go look at what the delta exposure on the position was, but I’m pretty sure that 100 RUT deltas would have been too much of a hedge. Maybe if it was IWM deltas, but I’d need to figure out what my long delta was at the time.