13
Feb
Credit Spread Trading System

Over the years we’ve received numerous inquiries about a credit spread trading system that involves the use of multiple credit spread simultaneously for diversification. The system consists of the following:

Trader uses 20 credit spreads simultaneously, does not make any adjustments, and then simply relies on probability to make money.

This system has a few requirements.

1. The underlying assets are not correlated with each other.

2. Each credit spread has a probability of 90% or higher.

3. User trades 20 credit spreads each month on different assets.

4. User never makes any adjustments and leaves all trades on until they expire in order to take advantage of the POP (Probability of Profit).

This trading system is purely about probability, and at first glance, it appears that it may work very well. In my opinion, there are a few inefficiencies with this trading system that I’ll explain.

First of all, for this credit spread system to be effective, the trader must find numerous underlying assets that are not correlated. But there is a problem here. Under normal market conditions, we may not see a strong correlation between the selected numerous underlying assets. However, once the market become directionally biased (extremely bearish or extremely bullish), then your NON-correlated can quickly become VERY-correlated. In other words, the correlation theory behind this trading system is really a set up for disaster. In fact, I’ve heard numerous stories of traders blowing up their accounts for this exact reason.

Let’s consider various scenarios to illustrate the problem with this correlation theory. Let’s say the trader initiates 10 Bull Put spreads and 10 Bear Call spreads while each vertical is placed with a different underlying asset. Again, this trader believes they have a high probability of success, and there is no need to manage any of the trades. The goal is to make money because of the high probability, and we assume that mathematically the winners’ profits will outweigh the losers’ losses. Consider what would happen over a serious market decline. Although each asset is theoretically not correlated, when we have a serious market decline, the correlation between all assets sharply increases. Therefore, it is highly probable that 10 out of 10 will realize there maximum loss. At the same time, the 10 Bear Call spreads will realize there maximum gain. This scenario is very similar to what would happen to one Iron Condor. So although the trader begins with a maximum credit of 10%, in this scenario the overall trade would assume a 100% loss since the trader loses the full amount invested into the trade.

A similar scenario occurs in a very bullish market. Most likely 10 out of 10 Bear Call Spreads will result in their maximum loss while all Bull Put Spreads realize a small gain. In other words, the trade once again results in maximum draw-down very similar to one large Iron Condor trade. So although this trading system seems like a good idea at first glance, it may perform similar to an Iron Condor, but it will be much more difficult to manage since there are so many trades to supervise.

Another scenario is that the trader only does one side of the trade. For example, let’s say the trader only does the put side. Again, in an extremely bearish market, it’s very likely that every single Bull Put Spread will realize the maximum loss. This is my point of view.

This is only my opinion, and I am speaking from experience of what I have seen happen in the markets over the last 20 years of trading it. You certainly don’t have to believe me, but what I would recommend is to back test this concept over those extremely directional markets such as 2008, 2011, and even the bullish moves of 2012 and 2013. It will be interesting work to be done, and as you back test this, you will discover one more problem with this trading system. It’s a ton of work and way too hard to manage! Even if you do not make adjustments, it’s still going to take up all of your time to research and fill your trades. Try backtesting it and you’ll get a good taste of just how much work this really is.

The last problem with this trading system is the obvious as I just started to discuss. Managing 20 trades at one time will be too much work for one trader. If you like to sit in front of your computer screen all day long trying to manage a portfolio of 40 strikes and 20 different underlying assets, be my guest.

Other risks include dividend risk as well as assignment risk. You’ll also pay higher taxes for trading options on stocks.

Finally, in order for this type of system to work, the mathematics have to produce a profit. Mathematically, the credit spread can yield about 10%, based on the required investment; however, the said trade can lose 100% of its investment. Therefore, one loser can wipe out 10 winners more or less. So remember this fact in your calculations before you attempt to profit from such a trading system for long periods of time.

Finally, Tsunami™ gives us further insight into this study. Tsunami™ can show us the statistical probabilities of each trade instead of theoretical probability that is produced in traditional software. In order to see if this technique has actually worked overtime, we could use Tsunami™ to better classify this trading system with statistcs. Perhaps in another study, we will continue this investigation. Thank you very much and as always… good luck with your trading!

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