Often, the markets themselves provide the best reminders of why we need to use all of the Monthly Income Machine entry rules when establishing our income-generating credit spreads and iron condors.
Now one of the many advantages that credit spreads offer includes the fact that they are essentially non-directional – i.e. we don’t care if our market goes up or down just as long as it remains out-of-the-money up to expiration day. But we do care if there is a really huge move in the direction of our spread that would threaten our established MRA (maximum risk amount) or worse yet, reach our strike price.
Case in point: many of us have found Netflix (NFLX) and Green Mountain Coffee (GMCR) fertile hunting grounds for spreads that meet the distance-from-the-market and the minimum premium entry criteria rules.
As of the time when this “white paper” article was being drafted, NFLX had an earnings report due during the October options expiration period, and GMCR had one prior to November expiry. Accordingly, neither should have bee used for credit spreads during their earnings report months.
Sure enough, ignoring that rule and establishing bull put spreads in NFLX in October or GMCR in November almost certainly would have produced a losing trade. Both made gargantuan down moves as a consequence of disappointing earnings and related announcements. So-called “headline risk” cannot always be avoided, but earnings report headline risk can and should always be off the table for SaferTraders.
Market-Wide Headline Effects
Obviously, not every potential headline risk can be cut off at the pass as easily as completely avoiding earnings report risk.
The market gyrations accompanying debt ceiling and debt downgrade crises, European default threats and politicians’ optimistic pronouncements about heading them off are current headline makers, but there will always be new ones – both positive and negative for the overall market.
The associated volatility is not necessarily a “problem,” TV pundits’ hand wringing notwithstanding. Volatility, after all, is the mother of premium – the prize conservative investors seek through disciplined, tactically sound use of credit spreads.
The good news is that we can, and should, manage this risk. For the credit spread income investor, one line of defense is intrinsic to the spread itself; the absolutely maximum risk is built into the equation by the limit of the strike price interval.
But a more robust approach than that relying on protection from the worst-case scenario is desirable for any investor, and is required of the conservative investor.
That’s the reason we urge you to set a MRA (maximum risk amount) for every spread based on a multiple of the premium you collected. And that amount will, of course, always be considerably less than the theoretical maximum loss.
Many “Machine” users also employ the recommended technique of using easily identified support or resistance level penetration as a signal for even earlier exiting from a trade that begins to look shaky.
No matter what you use to trigger a pre-expiration exit from a spread going the wrong way, be sure you have decided on it prior to establishing your position, and be sure that you have a stop order in the market to prompt the exit whether or not you happen to be watching the market when the headline flashes across the screen.
The Dirty Little Secret About Headline Risk
If nothing else, pay attention to this: Based on more than thirty years of market participation as a broker, educator, and trader, I can assure you that someone knows about the upcoming headline before you do! Consequently, the market often begins to move well before the news headline occurs… and the aforementioned stop may well prevent, or substantially lessen, an unpleasant loss well before the reason for the move is generally known.
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Note: We can – and do – guarantee your satisfaction with “The Monthly Income Machine” detailed how-to blueprint for conservative income investors. No one, however, can guarantee market profits. For a full description of the risks associated with such investments, see Disclaimers.
Nahhh, try to equally weight your portfolio in call and put credit spreads! Also iron condors and butterflies are really great non-directional spreads!
I try to avoid much of this type of problem by using ETF’s at the expence of smaller premium.