Trade Tutorial - Put Credit Spread (1/13/2012)

Having just closed one credit spread, I'm going to enter another one. I realize that this is Friday the 13th, but superstition has never been part of my trading strategy so here we go...

Credit spread trade setup

Trade
Sell DIA 121/119 put spread
ROI
32%
Exits
1. Exit if I can lock in 80% of my initial credit (i.e. $.10)
2. Exit if within 4-7 days of expiration
Credit $.49

I had mentioned in my last newsletter I might put on another bullish trade. Why now? Why not a bearish trade?

Why this strategy?

As we've made it into the first weeks of January, it has begun to look like the market is making its way slowly upward. It is not, however, an obvious conclusion that we are bullish long term. The failure of the market to act decisively is a bit concerning for sure.

As a result, I'm going to enter into a short term bullish position that I may eventually use to create an iron condor by adding a call spread. Of course that part of the strategy will need to wait until the market tips its hand. In the meantime, I'm going to enter this as an independent trade (a credit spread).

Choosing the right strike prices

As with all my credit spread trades, I have a consistent set of rules I follow about strike selection. This includes the rule about how I choose my short strike. I will look for a strike in an option month having at least 20 days until expiration and a probability of expiring between 30 and 35%.

Credit Spread strike selection

The January options have less than a week left so the obvious choice is the February option cycle. With volatility on the lower side, I have tended to lean toward the higher probability of expiring (ITM), which means a slighly lower probability of success in exchange for a slightly higher premium.

That means the $121 put as the short strike. As a result, my typical $2 wide spreads suggests I need to buy a $119 long put as the long strike to cover my risk. This spread is selling for $.49 credit, or $49 per contract.

Risk/Reward analysis

With a $2 wide spread, I have an absolute risk of $200. However, when I sell the spread for a credit I can reduce my risk by that credit. As a result, the risk in this trade of $151. The best way to evaluate this risk/reward is calculate as a return on risk. The way to do this is simply divide the reward by the risk amount. In this case, the return on risk is 32%.

That's not a bad return. In fact, for this kind of trade strategy, that's pretty decent. However, that's not the whole story. Many who follow these trade tutorials know that I never let the trade run until expiration. Instead, I close when I can lock in 80% of the credit. That means I'll target a closing price of about $.10 debit and keeping $.39 of the initial credit. That means my return on risk will drop to about 25% (.39/1.51). That's still not too bad.

Position sizing

My consistent rule about position sizing is to never create a trade that has a risk more than 2% of my portfolio value. Since this is a defined risk trade and I know exactly what the risk per contract is ($151), then it becomes quite easy to calculate the number of contracts I can sell.

My portfolio is currently $17,008, which means I can risk $340. As a result, I can sell just 2 contracts and remain within my risk tolerance.

Trade management plan

In general, I have a pretty simple trade management strategy for my credit spread trades. I will exit to lock in 80% of my credit (as explained earlier) and I will exit before expiration in order to not be subject to the risks associated with the last few days prior to expiration.

I also mentioned a plan to potentially sell a call spread at some point in the future. The ideal scenario for me would be to have the DIA move up to the $127-129 range and then sell a call spread above that area. I'll be watching for an opportunity to do this.

In the meantime, I will exit under the following conditions.

  1. I will exit when I can do so for $.10, which means I lock in 80% of the initial credit. That means a target profit of $78 for the two contracts sold.
  2. I will exit when approximately 4-5 days of expiration

Portfolio Impact

All my trades have three key characteristics to them.

  1. Defined risk - I know exactly what the absolute risk is in my trade
  2. Positive theta - My trades benefit from the passage of time
  3. Contributes delta in the direction of my current bias
Credit spread portfolio impact

As the above image capture shows, this trade (the only one running currently) adds positive delta, which reflects my current bullish bias. The image above also shows the positive theta impact of this trade. While the value of the theta is currently small, it will grow as we start getting into the last few weeks of the trade.

Update 1/27/2012

As usual, I'm way behind in getting these updates up on the page. Several things have happened with this trade that are worth covering.

First of all, I added a call spread as I suggested I might in trade management section above. As I mentioned at the entry of the initial trade, one thing I expected to happen was a potential run up to some previous highs and then a pullback. The challenge has been determining where the top is. On Monday, I looked at the gap from the 30 day moving average to the current highs and it seemed like we may start seeing some weakness.

credit spread adjustment

As a result, I looked at a call spread that had the typical characteristics of any credit spread I enter (probability of expiring and days until expiration). The strike I selected then was the $129 short call.

This left me with a $8 wide iron condor (that's equivalent to a $800 DOW swing). I was able to sell this spread for $.55, which makes the total credit for this trade $1.04. That means my risk in the trade drops to $.96. With two contracts on, my total risk is only $192. If I adopt the same early exit rule on this part of the trade (i.e. locking in 80% of the credit), I'll potentially lock in a net gain of $.83. That makes my return on risk 86%. Assuming this trade works out as planned, this will be a nice return.

Near the end of the week, the order to close the put credit spread triggered so I'm actually out for a debit of $.10. On the put side then, my net gain was $.39 as planned. I'm now left with just the call spread and my risk is now completely to the up side. Since entering the call spread earlier this week, the market has attempted to push higher with no real success. However, that doesn't mean next week wont' bring more buying.

I'll need to be vigilant with this one and may in fact close it early if an opportunity arises. After all, the call side is really a bonus to the original trade.

Update 2/13/2012 (Closing Update)

There's nothing wrong with taking profits. Repeat that until you believe it. Monday, saw the market starting to recover from the weakness of the week before. Given that it was the last week of the options month, it made sense to get out and take what profit there was.

How did this trade do overall? I had an overall credit of $1.04 for both the call and put spread. I bought back the put spread for $.10 and the call spread for $.39. That leaves a net credit of $.55 and a total trade profit of $110. The original plan with initial credit spread trade was to make $78.

Could I have done better? Of course, Friday might have yielded a better price but at that point it looked like there might be more selling ahead. Could I have waited for Wednesday when there was more selling? Sure, but there's no way to tell this was coming. Sometimes you've got to just take your profit and be happy. In the end, this trade made more money than the original credit spread was supposed to that that's good enough!

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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