Trade of the Week - Put Credit Spread (1/25/2010)

I'm going to dip my toe in the water with this credit spread trade. After several days heavy selling last week, it still isn't clear the trend has changed. However, I'm going to put a fairly tight leash on this trade.

SPY credit spread setup

Trade
Sell SPY 107/105 put spread
ROI
25%
Exits
1. Exit if I can lock in 80% of my initial credit (i.e. $.09)
2. Exit if cost to close >= twice initial credit (i.e. $.82)
3. Exit if within 4-7 days of expiration
4. Exit on close below 109
Credit $.41


Why this strategy?

People are probably thinking I'm crazy to put on another bullish credit spread trade right now. On the surface, that would probably case, particularly if I didn't have a backup plan. In the larger picture, the selling is simply a correction in the overall up trend. However, it is getting pretty close to being more than that. Taking a trade like this is a bit like catching a falling knife.

My plan is to take this trade according to my usual rules but add an exit of a close below Friday's low. That would make a lower low AND will have fallen through the area of consolidation formed back in November and December.

Choosing the right strike prices

Per my trading plan for the credit spread, I am selling the short strike at between 30 and 35% probability of expiring in the money. That gives me roughly a 65-70% probability of success.

Credit spread strike selection

With 25 days still left, here is still enough time in February to put the trade on. This is especially true with the volatility having risen sharply. Given the above short strike, I was able to price out a $2 wide spread for $.41. That's right about what I'd expect for this trade.

Why another trade on the SPY? First, because it represents a fairly broad segment of the market and right now, I'd prefer to be trading against the broad market. Second, with the price of the SPY in the $100 range, it offers pretty decent credits for my spread.

For more on why I trade ETFs, check here.

Position sizing

As always, I'm sizing my position using a consistent approach. The nice thing about a credit spread is that it always has built in a defined risk. In my case, that's $2 since this is a $2 wide spread. However, if I follow my typical exit rules, I'll exit on a worst case scenario when it cost me $.82 to buy back the spread. That means I'll lose $.41 or $41 per contract.

My portfolio has shrunk a little bit with the last few trades being losers. With a portfolio of $18,520, I'll risk just 2% of this or $370. That means I can take 9 contracts.

Of course, this strategy means I need to be ruthless in my exit to ensure I limit the loss to $.41.

Exit plan

My exit plan for a credit spread trade always has three components. A target profit point, a target loss point and a time limit. In addition, I sometimes have a technical exit as is the case this time.

My target profit point is to lock in 80% of the credit of $.41. That means I'll exit when I can do so for $.09, allowing me to keep $.32. That's a final ROI of 20%.

My target loss point (i.e. stop loss) is when I will stand to lose an amount equal to the credit. That means I'll exit when it cost me $.82 (I give back the initial $.41 credit plus I give up another $.41 of my own money).

I always plan to be out of the trade by the final week of the expiration cycle. I'm often asked why I don't simply let the trade expire since I keep the whole credit and don't have to pay any additional credit. I answered that question in my last monthly newsletter. To stay up to date on the latest newsletters when they come out, be sure and subscribe here.

Finally, I'm adding a technical exit since I took this trade in anticipation of a bounce from Friday's low. My decision to take this trade is based on the expectation that the upward trend will resume. A close below Friday's low of $109.21 (call it $109 just to be sure), would probably signal a failed bounce. Therefore, I'm going to add a mental exit to close this credit spread the day following a close below $109.

I will exit under the following conditions.

  1. I will exit when I can do so for $.09 - This allows me to lock in roughly 80% of the initial credit or about $.32.
  2. I will exit when it costs $.82 to close - I want to limit my loss on the trade to $.41 (the same amount as my credit).
  3. I will exit when approximately 4-5 days of expiration
  4. I will exit the day following a close below $109.

As always, I find it easier on my mind to use a mechanical exit order to enforce my first two rules above.

Credit spread exit orders

On the Thinkorswim platform, I can do this as a 'One cancels other' or OCO order.

Portfolio Impact

After being wiped out on my first three trades of 2010, I only have this one trade on. Since this put credit spread is bullish, it's not surprising to see positive delta. 

credit spread portfolio impact

The nice thing about this trade is that I've limited my risk in several ways, I have positive theta, which means I benefit from the passage of time, and this trade will also benefit from a decrease in volatility (negative vega). All these make this a good trade IF there is a bounce and SPY continues it's move up.  

Update 1/30/2010 (final update)

Well, I'm 0 for 3 on trades this year (not counting the trade I put on in late December). This is another bullish credit spread that didn't turn out too well. The good news is that because of my technical exit strategy, I was out with only a small loss.

I had a rule to exit if SPY closed below $109. On Thursday afternoon, SPY closed at $108.57 but gapped up on the open Friday morning. It looked as though maybe it would bounce there and resume a bullish run. However, I changed my stop order to market order triggered by SPY at or below $109. When SPY began to sell off later in the day, I was out of the trade for $.50 debit.

Since I put the trade on for a $.41 credit, I only lost $9 per contract on the trade or $81 total. SInce my absolute risk in the trade was $1.59, my loss percentage was 5.6% but the trade was only about .4% of the portfolio.

I knew this was a risky trade. It's a bit like trying to catch a falling knife, but I wasn't yet sure that the trend was changing. Following the break of $109, it's now clear the trend has changed.

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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