Credit Spreads over the Computer Glitch 1 of 2

The True Risk of Popular Option Strategies

San Jose Options presents what happened to those trading Credit Spreads and Iron Condors over the "Computer Glitch" debacle of May 6th of 2010. By watching this back test, you'll get a better grasp of how risky these trades really are.

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Credit Spreads over the Computer Glitch 1 of 2

Video Transcript

Hi everybody! How are you guys doing? This is Morris from San Jose Options and I just wanted to go over just a couple trades that are really popular and one of my favorite things to do is to make the public aware of the risk with options because there’s a lot of a risk with trading them.

I want to start with a credit spread, which is one of the simplest forms of vertical spread and pretty much, option traders normally start with a call and a put and then they move up to a credit spread. And then unfortunately, a lot of people stop there. It’s not too hard to get over that hump but you’ll find that a lot of traders just get to the credit spread and they stop. They don’t really learn anything more advanced or safer. But the problem with credit spreads is that they can work for a while, and then when they do work, what they do is they lead you into a month where you start putting more money in to your trades ‘cause you build up a little bit of confidence. Once this happens, ‘boom’, we have a debacle, we have a computer glitch, we have a 9/11 or something. Then the whole market goes down really fast and you end up losing, some people lose so much their whole portfolio on this type of trade.

Here’s an example right here. Recently, we had our computer glitch. I came up here and I set this trade to 420 starting on 20th.

Basically, what I’m doing is I’m timing it with 30 days out which is a pretty good starting point when you compare what most people are actually doing with credit spreads. I’m not advocating this type of trade, I’m just kind of making aware and showing you what happened recently to a lot of traders and what will happen to a lot more and what just happens all the time with credit spread traders. Here’s what’s going on, they’re choosing these trades about 30 days out. We’re using the Russell here which is pretty typical. Some people do these trades on stocks and so on but in this case we’re using the Russell. We feel we’re diversified that we have 2,000 different stocks that are I the Russell so we do have diversification. But it still doesn’t protect us against moments like these when we have a computer glitch and the dow drops a thousand points and the market goes out. I mean, our brokerage accounts weren’t even working. There’s really nothing we can do unless we had constructed safer trades from the beginning, which is what I’ve stressed.

Essentially, there’s no way to really adjust these trades. Once they start going wrong, the thing is we have to learn to construct safer trades at the beginning because things will go wrong. And when they do go wrong, then, you know, you’re going to wish that you just had started a safer trade from the gecko and not from trying to adjust when you’re having an emergency.

Here we are, 30 days out. I constructed a credit spread. I used a high prob one that was about a 8 delta, where I sold this. It brought in credit, 47 cents. This investment here, we have a 10 point spread. We brought in close to 50 cents, so it’s about 950, close to that, $950 somewhere in this trade. If we move this up here, we can see how the trade’s going. First it starts off right but you can see here in the trade for a while here, we stated on 420, so one day, two, three, four, five, six days after one week. You are in this trade on this time and nothing’s happening, you’re down to $7. So it’s about breakeven all this time and then we have our debacle and all sends down 30%. We’re in this trade for about 2 weeks, nothing happens and now it’s down 30%. Now at this point, what does a credit spread trader do? Plenty of them are stubborn and they just believe in the probabilities, so they don’t do anything. So your typical trader doesn’t do anything. It starts coming back, so now they’re about breakeven again. And they’re thinking, “Alright, great! This is why I do credit spreads. This is why I love them because I have this 90% probability.” Look what happens. They stay in the trade, now they’re down on a 600, we move this over so you could see what happens in the end and ‘boom’ they lost it all: $948.50. So they lost their whole account. This could be $900,000 to some people and that’s to your stubborn credit spread trader that’s going by probability. “Okay this is a 90% probability, I’m never going to lose on these things.” There you go. unfortunately, this happened to…