Uses and Misuses of Credit Spreads

In Part 1 of our 4-part series on Credit Spreads, we really drilling down and addressed the first topic in the series:

>> Why Credit Spreads Are So Hard to Repair

From here, we'll continue that series and cover:

>> Uses and Misuses of Credit Spreads (This Article)

>> Credit Spread False Logic and Faulty Math

>> Safe Sanctuary for Credit Spread Refugees

Quick Review

Last time around, I explained what a credit spread is (simultaneously selling and buying options and, in the process, collecting more for those you sell than you pay out for those you buy).

And I also said that, for the sake of this series, when I refer to credit spreads, I'm specifically talking about "vertical spreads" such as:

Bull Put Spread - selling a put at one strike price and buying another put at a lower strike price
Bear Call Spread - selling a call at one strike price and buying another call at a higher strike price
Iron Condor - simultaneously constructing a bull put spread and bear call spread on the same stock for the same expiration cycle

And to keep things as straightforward as possible, I said that I was primarily going to focus on bull put spreads in this series.

(But the same principles apply to all three versions of credit spreads above.)

Why I'm Not a Fan of Credit Spreads

I also explained why I'm not a fan of these kind of credit spreads - they're often very difficult and extremely expensive to repair.

They're much different than our cash-secured (or even margin-secured) put selling based Sleep at Night High Yield Option Income Strategy, where we have the tools to repair just about anything Mr. Market throws at us.

(And by "repair" I don't mean we simply avoid a loss, but rather we still generate positive returns - often in the decent to good range.)

So why are they so hard to repair?

Ironically - in the case of a bull put spread, for example - it's because of the component that's supposed to bring the trade so much protection - that offsetting long put you buy at a lower strike price.

Yes, that long put may cap your "maximum loss" as well as minimize the amount of capital required to secure or collateralize the trade.

But if you need or want to make any adjustments or rolls on the position, you're screwed:

You'll either have to roll your long put for a costly net debit (meaning you sell low and buy high on that portion of the trade)
Or you'll need to expand the width of your spread and replace your current long put at an even lower strike price (which then increases both your "max loss" as well as your capital requirements)

My point in the last article wasn't so much that bull puts, bear calls, and iron condors are impossible to repair - it's that they're impossible to repair when they're overleveraged.

And they're almost ALWAYS overleveraged.

In fairness, however, I would point out once again that credit spread advocates would say that these trades aren't designed to be repaired - they're designed to have high winning percentages that bring in more income than the heavy losses you incur on those trades you inevitably lose.

If that works for you, more power to you.

But it doesn't work for me because I absolutely detest the idea of ever losing money in the stock market.

But I digress . . .

Because what I really want to do here is build on what we covered last time and explore a valid way to use credit spreads that doesn't require you place your capital at risk of permanent loss.

The Insurance Company From Hell

If buying a put option is a form of insurance, then selling a put is very much like being an insurance company.

But instead of writing a policy to protect someone's Bentley or summer home in the Hamptons, when we write a put option, we're essentially insuring the share price of someone's stock.

Inside The Leveraged Investing Club, we take things one (very big) step further.

We don't just see ourselves as a regular insurance company - we see ourselves as "The Insurance Company from Hell."

That's because we collect lots of premium, but then we do everything in our power to avoid paying out a claim - which I define as either buying back our puts for a loss or allowing assignment of an in the money position.

You and I vs. Traditional Insurance Companies

Traditional insurance companies have a tremendous amount of scale which isn't available to you and me.

But when it comes to selling puts in the stock market, we have an insane amount of flexibility that they can only dream about in terms of "renegotiating" the original terms of the "policies" we write.

Whether you call it "renegotiation" or short put trade repair, we can do things that no insurance company can legally ever come close to doing themselves.

(I often refer to this flexibility as "Heads We Win, Tails Mr. Market Loses.")

But in the context of this article, I'm telling you all this merely as a way to lay the groundwork for what I consider to be the best use of credit spreads (or in this case, a bull put spread).

Reinsuring the Insurance Company from Hell

So there's another aspect of the traditional insurance company model that doesn't get talked about a lot - reinsurance.

In order to protect themselves, traditional insurance companies often purchase insurance policies themselves to offset some of their risk.

This is called, naturally enough, reinsurance.

Traditional insurers have the same choice we do:

#1 - To use reinsurance as a way that allows them to maximize their underwriting business without incurring losses that exceed their entire capital base

or . . .

#2 - To use reinsurance as a way to protect themselves only in the event of a catastrophic event

You can probably guess which one I prefer.

Bull Put Spreads = Reinsurance

Whether or not we've ever viewed bull put spreads in this way, the reality is that they really are a form of reinsurance.

Credit spread trade recommendation services are clearly using Reinsurance Approach #1 - leveraging up your put writing insurance operations and structuring things so that you can't lose more than you entire portfolio.

(How prudent of them!)

But that scale and leverage comes at a very big price - the expense of not being able to repair (or "renegotiate") your bad policies.

To me, the best use of a credit spread - again, a bull put spread in this case - is as a form of catastrophic event reinsurance.

We've already seen how flexible a selling or writing a regular cash-secured put can be (providing we adhere to the underwriting standards I spell out in the Sleep at Night High Yield Option Income Course).

That flexibility - along with our proven 4 Stage Short Put Trade Repair Formula - generally precludes the need for "reinsurance" on our part when we sell puts.

But I can tell you that having a long put in place on a trade where the underlying stock takes an unexpected dive is going to make that trade a hell of a lot easier to manage, repair, and renegotiate.

Say what?!? I thought you HATED credit spreads?

Remember, my contrarian position is that unless we treat our bull puts as though they're cash (or even margin) secured, we're overleveraged.

But when we aren't overleveraged - when we DO have sufficient cash or capital to accept theoretical delivery of the shares in question - the long put portion of our bull put spread can't hurt us.

In fact, it can only help us.

If the underlying stock really tanks - especially if it trades below the strike price of the long put - that long put is going to considerably increase in value.

At that point, the goal isn't to roll or repair the bull put. It's to convert it back into a regular old naked put and manage/repair it via The 4 Stage Short Put Trade Repair Formula.

In that scenario, the long put "reinsurance" of our bull put spread has done its job - we can now sell it back to Mr. Market for more than we originally paid for it.

That, in itself, is not going to repair the short put portion of the trade, of course.

But when you factor in all the accumulated net premium of the position, it's going to give you a lower breakeven or cost basis on the trade than you would've had with a naked put alone.

And it's at this point where the trade repairs kick in.

As is the case with options, it's all about trade offs.

>> If your original trade goes according to plan, and the stock behaves itself, structuring your insurance writing operations as a bull put spread is going to reduce your returns.

>> But if the stock makes a big move lower, you'll find your trade repairs much easier to conduct if you use the (non-overleveraged) bull put structure.

It Doesn't Have to be All or Nothing

So which is better - to use reinsurance (for protection, not leverage) or to not use it?

At the end of the day, it comes down to personal preference.

But I think the case can also be made for a third way.

Instead of ONLY selling cash/margin secured puts, or ONLY selling protective (not overleveraged) bull put spreads, maybe the best choice is to take things on a case by case basis?

When you're "insuring" a high quality stock trading at an attractive valuation and at or near key technical support, reinsurance (i.e. the bull put structure) arguably isn't needed.

But for trades where there's a little more uncertainty involved - even as you remain confident in your ability to repair it if it gets into trouble - then it may make sense to consider adding some protection to the trade.