Trade of the Week - Put Credit Spread (1/8/2009)

I'm putting on another credit spread this week. Why? Because I closed out of one of my January spreads and I wanted to get another trade on.

Credit spread on the SPY

Sell SPY 111/109 put spread
1. Exit if I can lock in 80% of my initial credit (i.e. approx $.09)
2. Exit if cost to close >= twice initial credit (i.e. approx $.90)
3. Exit if within 4-7 days of expiration
Credit $.42

This is a $2 wide put credit spread or short vertical spread. These two terms can be used interchangeably. We call it a credit spread because the initial entry results in a net credit to my account. I have also used the term 'short vertical spread' because technically, that actually describes the construction of the trade a little better.

Why this strategy?

It may seem a little odd to put another credit spread on in the same week as a 'trade of the week' or option trading tutorial, but I continue to be bullish in the medium term unless the charts start telling me something different.

The put credit spread is a nice strategy to use in this kind of market. When the SPY move up, I benefit in three ways.

  1. As the SPY moves away from my short strike, it decreases in value and my overall spread gets cheaper to buy back - ultimately reaching my target profit point.
  2. As the SPY and the market in general move up, volatility decreases, which in turn decreases the value of my short put, which gets me closer to my target exit faster.
  3. All of this happens as time marches on and as time melts away, so does the value of the spread

You get the picture. This is why I love this strategy in this kind of market.

I like the SPY right now because the S&P 500 is showing unusual strength and continues to reach highs not seen since the fall of 2008.  Of course, I continue to choose to trade ETFs because of all the reasons listed here.

Choosing the right strike prices

The trading plan I follow for a credit spread calls for selling the short strike having a probability of expiring in the money between 30 and 35%. On the Thinkorswim platform, this is a column that can be selected to be displayed on the monthly option chains on the trade tab.

credit spread strike selection

It's interesting that with over 40 days until expiration and almost a 35% probability of expiring in the money, the $2 wide spread is still only worth just over $.40. That  is due largely to the relatively low volatility.

Given the lower volatility, I'm starting to look to the next farther out month sooner than I used to when the volatility was higher. It simply means I may hold the spread a little longer.

Position sizing

As usual, I want to follow a consistent money management plan. I've continued to limit my risk per trade to just 2% of my portfolio (still around $20,000) . That means I can only risk $400 on this trade.

My exit strategy has a lot to do with how many contracts I can take. If I were to simply enter the trade and let it run until I get close to expiration, I'd have to be willing to risk the entire $2 (minus the $.42 credit I received). That would mean $1.58 or $158 per contract. That means I would only be able to take 2 contracts and remain within my limits.

On the other hand, if I follow my current exit strategy of closing the trade when I stand to lose the same amount as my initial credit, then I'm only risking $42 per contract, which means I could take 9 contracts and remain within my risk allowance.

If I chose to employ the latter exit strategy (which I will), I must be ruthless about following the exit. I'll talk more about how to do this in the next section.

Exit plan

Let's review my planned exits for this credit spread. I want to have at least one exit planned for locking in my profit, one exit planned for limiting my loss and any other exits that are part of my rules.

My trading plan has an exit strategy I call the 80%/100% plan. I'll exit if I can lock in 80% of the initial credit I received. In this case, 80% of $.42 is approximately $.09 (if I round up). I'll exit if I stand to loose amount equal to 100% of my initial credit. That means a closing price of 2 times the credit. In this case, that would be approximately $.84 but I'll round up to $.90.

I also have a planned exit to close the trade 4-5 days before expiration if neither of the other two exits have been triggered. I explained this in my last newsletter. If you haven't subscribed, be sure and do so. It's safe (I don't sell email addresses and I don't use them for any other purpose except sending you the newsletter).

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

  1. I will exit when I can do so for $.09 to close - this allows me to lock in 80% of my initial credit or about $.33 per contract (times 9 contracts is $297!)
  2. I will exit when it costs approximately $.90 to close - this will limit my loss to $.46 per contract or $414.
  3. I will exit when approximately 4-5 days of expiration

If it seems odd to be risking more than I stand to gain, consider that this strategy has a reasonably high probability of success (i.e between 65 and 70%).

In order to enforce my first two exit rules and to be ruthless about it as I mentioned before, I use a a special order called 'one cancels other' to ensure that either my 80% rule gets enforced or my 100% rule. See the picture below to get an idea of how this is done.

credit spread exits

The first is a limit order to lock in my profit and the second is a stop order to limit my loss. This is standard feature of the Thinkorswim platform. If you are using a different broker... consider switching (just kidding!). 

Check with your broker and ask if they support this kind of feature. It's critical to have unless you have the ability to monitor the trade all day long and the discipline of a machine to follow the rules every time.

Portfolio impact

I want to conclude by taking a look at the impact this credit spread trade has on my overall portfolio. No trade exists on its own but ultimately contributes to the collection of trades in the portfolio. With options, this has the potential to affect delta (directional bias), theta (the impact of time decay), and vega (sensitivity to volatility changes).

With the closing of my EWZ position earlier this week, I now just have the two credit spreads on and the remainder of a calendar spread, which is just a long put option. This long put is contributing a lot of negative theta, which skews this result somewhat. Since there's only about $.04 left on it, I doubt it's losing $9 per day.

credit spread portfolio impact

That said, this picture indicates I have a delta sensitivity of 123, which in simple terms means I will greatly benefit from a move up and would be hurt by a move down of the SPY.

I currently have net negative delta, which means I technically would be hurt by the passage of time, but as I said, I don't think my long put on DIA can hurt me any more. If I remove the -9 theta that this introduces, I have about 5.6, which means I actually benefit from the passage of time.

The other number I didn't circle but is worth looking at is the net vega position. I have a negative vega number, which means an increase in volatility will hurt me. When I was discussing why I chose this strategy, I said that a move up helps my trade in three ways. Two of those three factors actually hurt me with a move down. That's something to consider.

In summary, this says I am net bullish, I benefit from time eroding away (not counting DIA) and I would prefer to see volatility remain low or go even lower.

Update 1/15/2010

A week into this trade and we've seen some buying and selling, leaving SPY just a little lower than when I sold the spread.

A week later, even with the sell off this morning, this credit spread is still slightly profitable. That's because of the time erosion.

Credt spread trade update

Given the selling today, what might my actions be? There's really no action to take. I had considered selling a partial call credit spread to balance my delta but I don't think I want to do this today.

Given that none of my rules for exiting have been triggered the thing to do is hang in and watch the trade. Today is expiration Friday for January options so lots of wacky things happen. I think Monday will provide a clearer picture as earnings start being reported.

Update 1/22/2010

In this shortened trading week, it has been mostly selling. The net result is that we're lower today than a week ago.There's still some room before the stop triggers an exit.

From a technical analysis standpoint, there are actually two different support levels that may hold. Yesterday's selling broke through the 30 day MA and is sitting just above the 50 day MA. On top of that, the $111 area represents the top side of the consolidation area that acted as a resistance level and was broken in mid December.

credit spread trade

I expect one of two things to happen. This level will hold as support OR it won't and will likely signal more selling. There is no guarantee on which will happen but what does happen will give a good idea of whether the sentiment is shifting. 

I'll continue to monitor this credit spread trade and and will let my rules dictate my actions.

Update 12/23/2010 (Closing summary)

I wrote the above commentary yesterday morning but didn't get a chance to post it. I had said that the support level would either hold or break and if a break, the trend may be changing.

So, how does the trend look now?

credit spread exit

It's highly likely that the trend is changing... maybe to a range bound market or a full out bearish market. 

As a result of yesterday's move, I got stopped out of this credit spread at $.93, which means I lost $.41 times 9 contracts for a total of $369 or about 2% of my portfolio.

While it's always a bummer to be stopped out and lose money, I would rather have that happen at $.93, losing $.41 than to be fully in the money and lose $1.60 at 9 contracts. I also got stopped out on my other DIA trade. Imagine losing $2000 in one day on a $20,000 account.

I started the year determined to trade the trend, not fight it. While it's tempting to feel betrayed by that decision (3 out of 3 bullish credit spreads stopped out), I now have an opportunity to adjust my trades to the current market. And, it didn't cost me that much to have that happen.

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

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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