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Tales of a Technician: What Do I Do When Credit Spreads Go Awry?

October 8, 2018

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Long-time readers know I’m an advocate of scaling-in when selling naked options or credit spreads. The idea is to split your position into two or three tiers and to enter them at different prices to increase the odds of success. I’ll link to a few previous articles below if you need a refresher. I received a question from Jacques that I want to respond to in today’s blog.

“…I’ve recently started utilizing scaling in and just love the idea. I’ve got 3 questions about management, when a trade goes against you on a bull put and you scaled in 3 times. when is the right time to roll the trade? When you roll the trade do you scale in again? when do you decide not to roll and just close the trade at a loss?”

Let’s tackle the first regarding the right time to roll the trade.

First, I never roll further OTM in the same month (aka roll down). If I’m going to adjust it’s only because my bull put is sitting ITM at expiration and I need to extend the duration of the trade to avoid being assigned. I would roll out typically when we are around five or maybe ten days to expiration if I want to reduce risk. Furthermore, unless my timing was atrocious on the second or third tier, I highly doubt I wouldn’t have at least had the chance to exit one of my tiers at a profit. Consider this example on ABC which is trading for $100.

Tier 1: Sell Nov 95/90 bull put for 50 cents. Target 10 cents

Tier 2: Sell Nov 95/90 bull put for 80 cents. Target 40 cents

Tier 3: Sell Nov 95/90 bull put for $1.10. Target 70 cents

Because my target on tier 2 and 3 are higher than tier 1, there’s a good chance if I get some type of bounce in the stock between now and Nov expiration that allows me to grab a profit to reduce my position back to 1/3 or 2/3 size. That means if after the bull put value rises to $1.10 and I’ve placed all three tiers, a rally in the stock should reduce the put spread value back to 70 cents at some point so I can at least capture a profit on the third tier.

I’ve also found that if I’m patient, sometimes I can get a credit well above 1.5 to 2x the original premium received on the first tier. For example, let’s say I sold a Nov 195/190 bull put for 59 cents and didn’t add the second tier until $1.72. That means I allowed the position value to move about 3x the initial premium before I pulled the trigger on the second tier.

Nonetheless, if I’m dead wrong and whiff on all three entries and ABC is sitting at $94 near expiration placing my bull put ITM slightly, then I would roll to a Dec bull put in the week or so leading up to expiration. I’d probably try to roll down in strike to widen the profit zone (maybe using the Dec 92.50/87.50 bull put) if I could do it for even or a credit. It’s a judgment call as to when you pull the trigger on the roll, but I would typically wait until ten days to expiry. Closer than that and the gamma risk can get nasty.

The second question- do I scale in again when I roll?

No. You’re in a full position at this stage (assuming you’re in all tiers). So either roll the whole thing or don’t.

Third question – When do I just close it at a loss?

This one is trickier. It depends on how much I like the stock/ETF and whether I want to maintain my exposure. If it’s a stock with earnings looming, then I’m less likely to roll out. This is why I like ETFs because I can keep rolling and managing the position until I become profitable. XOP is a good example. I was short puts on it from Dec 2016 to Sep 2017 when it dropped 30%. But because I rolled, and sold calls along the way to hedge I eventually made money. Had I known it was going to trend lower for six months I probably would have exited and played elsewhere but YOU NEVER KNOW.

I plan to dedicate this Thursday’s Cash Flow Club to these questions and walk through my plan for managing losing bull puts in the current market environment. I’ll be using losing trades in HD, TLT, AMD, and EEM to illustrate.

Scaling-In Articles:


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1 Reply to “Tales of a Technician: What Do I Do When Credit Spreads Go Awry?”

  1. EmilyBridger EmilyBridger says:

    Starting to understand this better! Thanks for laying out the details and sharing with us all. Looking forward to Thursday’s Cash Flow Club!

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