Credit Spread False Logic
and Faulty Math

Our in depth and honest series on credit spreads continues.

So far in this series we've examined a pair of critical issues with credit spreads (i.e. vertical spreads like bull puts and bear calls):

Part 1 - Why Credit Spreads Are So Hard to Repair - it's hard - and expensive - to repair a trade when every time you touch it, it costs you money.

And that's the problem you face when trying to roll any trade that has a "long" component, such as the long offsetting put in a bull put spread construction.

You're ALWAYS going to pay more to buy a new long put than what you'll be able to sell youR existing/expiring long put for.

Part 2 - Uses and Misuses of Credit Spreads - In this article, I made the case that the best use of credit spreads is to treat them as regular cash-secured (or even margin secured) naked puts with some re-insurance tacked on to protect you from a big, unexpected drop in the stock.

My controversial and contrarian position is that unless you can theoretically accept full delivery of shares connected with the puts that you sell in a bull put spread, you're overleveraged.

In other words, if you don't retain the financial ability to convert your bull put spreads back into regular uncovered/naked puts, you can kiss trade repair good-bye.

(I also conceded - in fairness to credit spread promoters - that the credit spread model isn't based on repairing bad trades but rather boosting winning percentages and hopefully limiting the damage on the trades that inevitably do go against you.)

And in our final two installments in this series, we're going to cover:

>> Credit Spread False Logic and Faulty Math

and . . .

>> Safe Sanctuary for Credit Spread Refugees

Credit Spread False Logic and Faulty Math

OK - this is going to be fun, especially if - as I said last time around - you like playing whack-a-mole.

Because most of those who promote credit spread training and trade picking services like to have it both ways:

>> They talk about the amazing ROIs that are available to credit spread traders

>> And they talk about the "limited risk" aspects of the trade

But what they won't tell you - because it gets lost in the shuffle of all their bullshit - is that you can't have both at the same time.

Throwing a No-Hitter on the 4th of July

So way back in the 1980s, when I was in junior high school and high school, I was a huge New York Yankees fan.

One of my favorite players was pitcher Dave Righetti (who's been the pitching coach for the San Francisco Giants for forever it seems).

Back in the '80s he was a lot of fun to watch - he just looked like a ballplayer.

He was a hard throwing left-hander and he struggled with control in his early years, but when he was on, he was on and used to just mow down the hitters.

He struck out 160+ batters in 1982 and 1983.

The pinnacle of his starting pitching career came in 1983 when he threw a no-hitter against the rival Boston Red Sox - and on the 4th of July of all days.

He even struck out Hall of Famer and .328 career hitter Wade Boggs (who hardly ever struck out) not once, but twice that day - including to get the final out of the game.

Here's a cool YouTube video showing that final at bat:

But Then Something Happened

In 1984, the Yankees lost their dominant closer - Rich "Goose" Gossage - when he signed with the San Diego Padres as a free agent.

Those were some big shoes to fill.

When the Yankees previously lost Gossage for most of the 1979 season from injuries sustained in a locker room fight with teammate Cliff Johnson (God, I miss the '70s!), the team who had just won back to back world championships finished the season in 4th place.

Meanwhile, in 1984, the Yankees felt they had a deep enough bench of starting pitchers, especially after they'd signed knuckle ball master Phil Niekro.

The solution the Yankees came up with then was to give the role of closing relief pitcher to Righetti.

He didn't disappoint and he had some great years in that role. Such as in 1986 when he set the record (at the time) for most saves in a single season (46).

But the Decision Remained Controversial

A lot of fans wanted to Righetti to remain a starting pitcher.

And by the late 1980s when the Yankees' starting pitching had completely fallen apart, those views had a lot to back them up.

(In fact it got so bad, that in 1990 the team finished in dead last.)

The decision to move Righetti from the starting rotation to the bullpen still gets debated today.

What kind of career numbers could he have put up as a starter?

How many 20 game winning seasons might he have had?

How many more shutouts or even no-hitters would he have thrown?

How many more games would the Yankees have won as a team with a reliable, quality left hander in the rotation and someone else as the closer?

WE HAVE TO MAKE CHOICES

Life is about making choices, and sometimes those choices aren't easy.

Maybe it's because it's a decision where there simply aren't any good choices in the first place.

Other times, however, as was the case for the ' 84 Yankees, the choice to keep Righetti in the starting rotation or move him to the bullpen was tough because he had the skills to succeed in either role.

There was a good case for keeping Righetti in the rotation.

And there was a good case for moving him to closer.

But the one scenario that was completely off the table was the idea of asking him to somehow play both roles at the same time.

"Hey, Dave, we want you to start every 5th game. And, oh yeah, we'd also like you to be able to come in off the bench in the late innings when we really need to hold a lead."

That would be crazy, right?

But, strangely, that's exactly what credit spread promoters want you to think YOU'RE going to pull off.

"Hey, we've got this kick-ass strategy where you can make crazy returns - 20%, 30%, 40% - in short order.

"And the best part is that it's a limited capital and limited risk trade - it takes very little capital to set up, and your maximum loss is capped at a small amount."

What they don't tell you is that a high return on a small amount is an even smaller amount.

If I risk $200 to make $50, then my potential ROI is an fantastic sounding 25%.

But if I'm only making $50 on, say, a $100K portfolio, that's a paltry 0.05% gain.

Easy enough problem to solve, right?

If I have a $100K portfolio, then surely I can risk a hell of a lot more than $200, right?

So let's say that instead of risking $200 to try to make $50, I instead risk $20K to try to make $5K.

That's still the same terrific 25% ROI on the capital at risk, or 5% on the value of the entire portfolio - an improvement, to be sure, especially if the holding period is only a few days to a few weeks.

But look what I've done - I've potentially set myself up to lose 20% of my entire portfolio in a single trade if anything goes seriously wrong.

(Ha - what could possibly go wrong in the stock market?)

Yikes.

Yes, that's technically LIMITED risk in that there's a limit to how much you can lose, but it sure as $#!$ isn't LOW risk.

More Straw Men Arguments?

As I said previously in this series, I'm not trying to make straw man arguments but rather just illustrate a point.

And that point is that you can't have truly high ROI returns AND truly low risk trades at the same time when trading credit spreads.

And anyone who tells you otherwise is either being dishonest or they simply don't know what they're talking about.

Whether it's intentional or not, it's still false logic.

And saying that it's all a matter of how you set up and manage your credit spreads doesn't mitigate that fact.

Because this is where the faulty math comes in.

Credit spread traders may have a rule where they never risk, say, more than 5% of their capital on a single trade.

But what good does that do if the entire market makes a big move on you (and n the wrong direction)?

You may think you're diversified, but if you've set up 20 different credit spreads, each representing 5% of your total capital, you've still risked everything and could easily get slaughtered.

Another "workaround" that I find to be disingenuous is the idea that you can effectively limit your losses on the trades that move against you.

Sounds great on paper, but in the real world, it's much tougher to pull off.

For example, I recently viewed a webinar where the host targeted 15-20% returns on his credit spreads and had a rule that if the losses on a trade ever hit twice his max potential profit, he would cut his losses and exit the trade.

Again, sounds great in theory, but there are a couple of serious problems with that:

>> Just because a credit spread initially trades against you - triggering your exit - that doesn't mean the trade wouldn't have worked out by the time expiration rolls around if you'd just left it alone.

The webinar host's premise was that he could win 75-80% of his trades, and those trades where he lost, his losses were manageable and limited.

But in a volatile market, you're going to get stopped out of more of your positions and really tank your "winning" ratio - and you're going to have more positions where it was a mistake (in hindsight) to exit while the trade was down.

Stocks zig and stocks zag, and sometimes a trade moves against you only to return full circle and close at expiration pretty much where it was when you first entered the trade.

>> I also find the assumption that you can pick with precision the point at which you exit a trade to be problematic.

The options market is not like that of a highly liquid, mega cap stock where everything is priced to the penny and you have no problem getting in and out of a position.

Options are leveraged derivatives where moves in the underlying stock are magnified.

So you may have a rule that says you're going to exit a position if the spread increases and hits a certain value.

But you may wake up one day to find the stock has gapped the wrong way on you and your losses are now a whole lot more than where you said you'd get out.

And don't forget that commissions and inefficient bid-ask spreads can also take a toll on the pricing you're able to get.

SUMMARY

I'm not saying vertical credit spreads are evil.

But if you're going to trade the strategy, you really need to fully understand the con side of the ledger, not just the rosy idealized outcomes that those who promote credit spreads exclusively focus on.

You really need to understand their limitations and their risks.

Bottom line - credit spreads are difficult, if not impossible, to repair the way they're most often constructed.

And while there are conservative and safe ways to use the strategy, I find that very few traders actually do so.

When the choice is increased leverage vs. increased safety, most traders are going with leverage.

Even as they try to convince themselves they're doing the opposite.

Next: Part 4 - Safe Sanctuary for Credit Spread Refugees

Next time around, we'll conclude our series by looking at the human side of these trades.

Specifically, I'll share some of the stories I've personally been privy to from years of working with individual investors and traders inside The Leveraged Investing Club.

And we'll also talk about people I affectionately refer to as "credit spread refugees," and what you can do if you happen to be one yourself.

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