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Trade of the Week - Put Credit Spread (01/04/2010)

I put this credit spread trade on this morning as the market was just beginning to take off. It's another short put vertical spread on EWZ.

Credit Spread on EWZ

Sell Feb EWZ 72/70 put spread
1. Exit if I can lock in 80% of my initial credit (i.e. $.10)
2. Exit if cost to close >= twice initial credit (i.e. $1.02)
3. Exit if within 4-7 days of expiration
Credit $.49

This evening as I write up the summary of this trade, it looks like a genus trade. However, it's just one day and anything can happen over the next 46 days.

Why this strategy?

As I mentioned in one of my recent trades and also in my eZine, I'm determined to trade the trend I see this year and at this point, it appears to be bullish.

I have traded EWZ many times over the last year and it continues to show a strong upward trend (most of the time). I actually considered a diagonal spread instead but the cost was a little too high. Volatility seems a little higher as well, which contributes to the higher cost. 

Instead, I chose the credit spread (short vertical spread) because it continues to be one of my favorite options strategies and is perfect for this kind of trend and market.

Choosing the right strike prices

There are two aspects to choosing the right strikes. One is selecting the month and the other is selecting the strike prices. I initially looked at a credit spread in the January expiration cycle but there are only 11 days left. I'd like at least 20.

The February options still have 46 days left, which is perfect.

In terms of the strike price, my usually preference is to pick a short strike that has between 30 and 35% probability of expiring in the money. That means a rough probability of expiring worthless of between 65 and 70%. 

Credit spread strike selection

As the above image illustrates, this provides a nice profit point where I can capture a credit of almost $.50 on a $2 spread and only have a max risk of $1.50. That's an ROI of about 33%.

As it turns out, the best I could get is $.49. That drops my ROI down a little but not too much.

Position sizing

My trading plan for the credit spread strategy is to limit my loss in the trade to an amount equal to the credit. In this case, that would be $.49. That would mean exiting when the cost to close is $.98.

Since I'm risking $.49 (or $49 per contract), I can sell 8 contracts and still remain within the 2% trade risk of $400 on my $20,000 portfolio.

That will yield a potential profit of $392 if the options expire completely worthless. I won't do that, however.

Exit plan

Also part of my trading plan is my three core rules for exiting a trade. I choose to exit if I can lock in 80% of my initial credit. Rounding up, that means if I can close for $.10, I keep $.39.

As I mentioned on position sizing, I'll close if it cost two times the initial credit or $.98. I'm going to round this up a little bit and make it $1.02. I do that just to give a little more wiggle room.

Given the trend and the consolidation pattern that built up over the past couple of days, I'm going to be closely watching any break down below the $74 level. I don't know that I'll exit just yet, but I might since I will likely be able to exit earlier than my 2X exit and thus preserve some of my capital

Just to summarize, I will exit under the following conditions.

  1. I will exit when it costs $1.02 to close - I want to limit my loss on the trade to $.52 per contract
  2. I will exit when I can do so for $.10 - This allows me to lock in roughly 80% of the initial credit and still will yield a decent ROI.
  3. I will exit when approximately 4-5 days of expiration

As I mention on each of my credit spread trades in particular, the best way I know to make sure I follow my rules is to use mechanical stops and limit orders. On the thinkorswim platform, I can use the 'one cancels other' OCO setting to put together two orders that will either close the trade to lock in my profit or close the trade to limit my loss per my rules 1 & 2 above.

Credit spread exits

Here's what the order looks like. I'll put the order in as good until canceled and just wait for the trade to develop.

Portfolio Impact

Given that this is a bullish trade, it's not surprising to see that this trade adds positive delta to my overall position.

credit spread portfolio impact

Not only that, but it helps offset the current negative theta (time decay) that I have due to the remnants of the calendar spread that I still have on the DIA.

If the current trend continues, I'll probably be looking for another bullish trade to put on, which will add more positive delta and more positive theta.

I could also put on a bearish credit spread (short call vertical) if I wanted to add positive theta but become more neutral. In fact, I could do that with either of my two current spreads and form an iron condor.

Update 1/14/2010

Over the past week plus that I've been in this credit spread, EWZ has gone up a little and down a little and is currently lower than it was the day I put the trade on. That said, the spread value is roughly the same as it was when I put it on.

Why is that? It's primarily due to time erosion. There are still 36 days until expiration so a lot of the erosion is still to come. That's what I love about the credit spread strategy.

I'll continue to be monitoring this positions relative to the 30 day moving average and other support levels. A break of the 30 day and 50 day moving averages could be an important early warning indicator. If that happens, it would be the second time in a few months where the moving averages failed to hold as support. 

At the very least, I might consider lightening my risk in the position.

Update 1/20/2010 (Final update)

I guess I waited too long to take action. Actually, yesterday, it looked like there would be a support bounce in the vicinity of the 30 & 50 day MA. However, this morning, my stop triggered and I'm out of this credit spread trade.

The order actually filled at $.66 even though the stop was set at $1.02. That could be for a number of reasons, but likely it was due to the crazy market action in the first few minutes of trading. This sometimes affects the Mark price on the spread, which can provide misleading triggers. Since the stop order turns into a market order, I got filled at the actual market price. This is one of the risks of using a mechanical stop. Sill, I'd rather that happen then being left holding a trade that is a major loser.

As a result of this early exit, I lost $.17, which is an 11% loss on my initial max risk or amount I put up in margin. Put another way, of the total $1.51 I could have lost if the trade experienced a max loss, I only lost 11% of that. I sold 8 contracts for a total loss amount of $136 or .6% of my portfolio (that's less than one percent)

credit spread technical anysis

After all of that, EWZ recovered from much of its early losses leaving a question as to whether the next move is more selling or a bounce. Those familiar with Japanese candlestick chart patterns may recognize a potential hammer forming. If confirmed, it would be a bullish signal and may present an opportunity to re-enter. 

It is important if if this not be a revenge trade. I'm not entering try to get some of my money back. If the trade makes sense AND I would have considered entering the trade on its own merit, then it may make sense to construct another trade - perhaps another credit spread. In the mean time, this will be the final update on this trade.

Rule # 1 - Don't lose money.
Rule # 2 - Never forget Rule #1  (Warren Buffet)

Stay tuned for further updates as the trade progresses...

Note: This trade discussion is for educational purposes only. I am NOT making any recommendations on the trade or the underlying stock or ETF. If you decide to follow this trade, please do so in a paper trading account. Trading options involves risk and some options strategies can result in losing more than the original amount invested.

thinkorswim, Division of TD Ameritrade, Inc. and Success With Options are separate, unaffiliated companies and are not responsible for each other's services and products.

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