Trade Tutorial - Put Credit Spread (1/26/2011)

This is a put credit spread.  After some selling and 'apparent' recovery, I'm going to take this as an opportunity to enter another bullish position.

Credit spread trade on IWM

Sell IWM 76/74 put spread
1. Exit if I can lock in 80% of my initial credit (i.e. $.05)
2. Exit if IWM closes decisively below $77
3. Exit if within 4-7 days of expiration
Credit $.43

The nice thing about this trade is there is a clear point near $77 that is an established support level. This can act a s a line in the sand as to when to exit early.

Why this strategy?

After continuing the consolidation into early January, IWM pushed to new highs before selling off. It appears that we now have a bounce - in fact as I put together this trade page it seems obvious this is a bullish bounce. However, time will tell. In the mean time, it seems like an obvious opportunity to enter a bullish trade.

As I considered various strategies, it was clear to me this bounce was far from a certain thing and certainly wasn't guaranteed to be a long term bounce. As a result, I went to one of my favorite strategies because the credit spread is a fairly short term strategy. If things continue to go well, the trade could be closed in a matter of weeks. I also like the overall fault tolerance that the credit spread offers. If IWM simply stalls at this point or simply grinds its way higher over a much longer time period, the trade will still make money.

Choosing the right strike prices

My trading rules for a credit spread call for looking for a short strike price having 20 days or more and a probability of expiring ITM of between 30-35%.

Credit spread strike selection

At the time I entered this trade, the best strike price was the February short $76 put. Since I enter $2 wide on these trades as a rule, that means my long strike will be a $74. This trade can be entered for a $.43 credit.

Risk/Reward analysis

With a $.43 credit on a $2 wide spread, that means my risk in the position is $1.57. The reward/risk on this trade then is 27%. Since the risk amount of $1.57 is actually the amount of my own money I'm required to put up in margin on this trade, I could say that this amount (27%) is also my return on investment.

In past trades, I've attempted to improve my reward/risk ratio by closing the position with a smaller potential risk amount. This allowed me to take a larger position size and have trades that had reward/risk ratios of closer to 80%. The downside was that the early exit rule I was obliged to put in place to accomplish this often kicked me out of a trade prematurely. So, while my potential reward/risk ratio was higher, my success rate was lower.

As I've mentioned in recent trades is that I'm going to change my exit strategy and entry rules to allow for a maximum loss. This will allow my trades to run longer and potentially have a higher success rate. The trade-off is that I have a lower reward/risk ratio.

Position sizing

I've already mentioned that my risk in this trade is $1.57. In every trade I enter, I am risking just 2% of my current portfolio value. At this moment, my portfolio stands at $17,061. That means I can risk $341 on this trade.

That means that I can only sell 2 contracts and remain within my risk threshold. That may not seem like much but I intend to enter more trades at various points in time.

Exit plan

Because of the fact that I'm not using an early exit rule for limiting loss, my exit rules now are much simpler. However on this trade, I think a good additional rule to add would be a technical one. I entered this position on the basis of an apparent bounce at $77. I believe that if IWM were to fall back down and close below $77, this would be cause for exiting the credit spread.

How will I enforce this? Instead of having an explicit exit rule enforced by a stop loss order, I am going to set an alert that will trigger when IWM trades below $77. This will alert me to watch more carefully.

I will exit under the following conditions.

  1. I will exit when I can do so for $.08 - This will allow me to lock in 80% of the initial credit.
  2. I will exit on a close below $77 - This will potentially limit my loss and allow me to exit a little earlier.
  3. I will exit when approximately 4-5 days of expiration.

Portfolio Impact

Prior to entering this credit spread, I was all in cash as all other trades had been closed. This is a bullish trade so I'd expect the resulting portfolio greeks to reflect that.

Credit spread portfolio impact

In this case we have a positive delta as would be expected and a positive theta. That means I have a nice bullish position that benefits from the passage of time.

Update 2/7/2011 (closing update)

And... we're out. This trade turned out to be another textbook trade that went exactly as planned.

I put this trade on for a credit of $.43 and closed for a debit of $.09 making my net profit in this trade $.34. Since the initial risk on this trade was $1.57, the return on risk for this trade ends up being 21%. That's not too bad for this kind of trade.

In closing this trade page out, I wanted to comment on the fact that to date, I haven't had a chance to really test the case where the trade went significantly against me. Remember that I've changed my position sizing strategy with the idea that I will allow the trade potentially to experience the maximum loss. The motivation for doing this is that it gives me more room (and more time) to allow the trade to correct itself. As I mentioned, so far none of the trades I've entered with this position sizing approach have been tested in this way. However, I'm sure one will come along soon.

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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