Option Credit Spreads

Topic: 2 Way and 4 Way Credit Spreads

Dear Options Trading FAQ:

Can you go over what the difference (max gain and loss) for this option strategy: a 2 way spread and a 4 way spread on the OEX Index? Let's use the same strike price and expiration on the 2 way as in the 4 way (the other half of the 4 way can obviously be at a different strike price). I can't seem to find a software package that will help me on this.

Thanks,

Spreading ‘em in South Carolina

Dear Spread’em:

Let’s assume that all the readers know what a regular 2 leg credit spread is (e.g. With the OEX Index at 554, Buy an OEX Oct 575 Call for 1/2 and Sell the OEX Oct 570 Call for 1, resulting in a 1/2 credit. You then hope for the OEX to expire this month under 570 so that you can keep that 1/2 credit.) A 4 way would also involve the put side of this example - that is, also buy the OEX Oct 535 Put for 1 7/8 and sell the OEX Oct 540 Put for 2 1/2 resulting in a put credit of 5/8. The total premium collected for this 4 way is 1 1/8. You would collect the entire amount if the OEX settles between 570 and 540.

The max loss for the OEX call spread is usually considered to be the difference in strikes less the premium - in this case, 5 minus 1/2 equals 4 1/2 max loss. On the 4 way it would be that plus the requirement on the put side - 5 minus 5/8 equals 4 3/8. In other words, you risk a total of 8 7/8 to make 1 1/8 with a width of 30 points in the OEX.

Notes: In strongly trending rallies (like the market we’ve been in) YOU WILL GET KILLED IN THIS OPTION STRATEGY. Month after month you will get hit on one side - sometimes all the way to the max loss. This is a strategy for tight range markets (like before the bust out a year ago).

In the OEX, which is an American style exercise, YOU CAN LOSE MORE THAN THE DIFFERENCE IN STRIKES LESS THE CREDIT. This is due to early assignment where the spread is broken on you and the long side you are left with gets tanked. Use European style exercise options like the SPX. This is a complex issue which very few traders realize. I will address it in a future letter.
Send for free literature on spread trading from the CBOE at (800) OPTIONS.

A reader replies:

You said

>>On the 4 way it would be the spread requirement of the call side PLUS
the requirement on the put side (also the difference in the strikes less the credit). In other words, you risk a total of 8 7/8 to make 1 1/8 with a width of 30 points in the OEX.

>This confuses me. I would expect that if it is about 570, the puts are
worthless, and vice versa, so that you're actually only risking 5 - (1/2 + 5/8), which seems much more reasonable.

>Though, as you note later, early assignment can mess you up if the market
reverses.

The Options Trading FAQ replies:

Good thought. In theory, the OEX settlement leaves one side of the 4 way out-of-the-money if the other side is hit. If so, then why does the exchange require margin for both spreads and not just one? The answer is the risk of a highly volatile market. Let’s say the market jumps for a couple of days, you get nervous about the upside risk, and so close down the call spread for a 3 1/2 point loss (you took that loss to avoid it becoming the maximum upside loss of 4 1/2).

According to the options margin man, at this point, one CANNOT assume that the other side is totally out of danger (in real life, barring a real disaster it is -assuming your spread is wide enough.) He envisions the following scenario: As soon as you close out the call spread, the market crashes and the put side becomes in danger. That’s why the margin is for both spreads - they are worried that you won’t hold on until expiration but get cruelly whipsawed instead.
In fact, as you note, the occurrence of an early assignment may really throw things out of kilter, forcing you to take an early loss and not giving you the option of a play clear through to settlement.

Same reader further notes:

Options Trading FAQ wrote

>> In strongly trending rallies (like the market we’ve been in) YOU WILL
GET KILLED IN THIS STRATEGY. Month after month you will get hit on one side - sometimes all the way to the max loss.

>If strongly trending, wouldn't the loss be only in one direction, and
thus the smaller amount I calculated? Or have I misunderstood trending?

Options Trading FAQ reply:

You are right. The loss is on one side only. The tragedy in this type of market is the extent of that loss and its frequency. Even on the one side, you are risking 4 1/2 to make 1. If you let the loss go to the max, the winning side premium (in this case the put spread) made you only a 1/2 giving you a total loss of 4 points. Here is the implication: On a successful month, you make a point or so. In a flat market, these points will steadily add up to a great annual return. In a year when the market trends one way strongly, a string of bad months will occur. A max hit of 4 points puts you 4 months behind (if you're only bringing in about a point each month.) If you get hit another time (back to back), that’s 8 months to make up. Your year is shot. This strategy works great in the long run but in the current type of market, there’s hell to pay.

GENERAL NOTE: I congratulate everyone on the depth of the option strategy questions and comments I get regarding these posts. I truly enjoy and appreciate the careful thought behind questions such as this one.

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Strategy, Options Exercise, Options Spreads

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