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Trade of the Week - Put Credit Spread (2/9/2010)

Yup. It's another put credit spread. After a few weeks of solid selling, I'm thinking it's time to start being a little more bullish - at least in the short term.

Credit spread trade on SPY

Sell SPY 103/101 put spread
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. $.92)
3. Exit if SPY closes below $105 or so
3. Exit if within 4-7 days of expiration
Credit $.46

It may seem a little risky to put on a bullish credit spread after this tremendous move down but I'm I have a reason

Why this strategy?

I decided that after several weeks of selling, there might actually be a relief bounce that takes place. Or... perhaps this will be a bounce that turns into the next bullish run.

What I'm looking at is a couple of things. Notice that the selling on the SPY has taken it down almost to the 200 day MA. I would have felt better if it had actually touched and bounced but that doesn't always happen.

The caution on this trade is that this might become a failed rally as indicated by SPY failing to break through the $111 area. If this happens or the next few days result in a close below yesterday's close (the last read candle), then I will manually close the trade.

In the mean time, if this does become a nice bounce, then the move up combined with the drop in volatility and progression of time make this the winning triple combination for a put credit spread. If this doesn't turn into a strong bounce but results in chopping around and sideways trading, this trade will still make money.

Why the SPY again? I like this ETF. I've gotten to know it and it is very liquid, both in the stock itself and the options. The fact that the options trade in $1 strike increments is ideal since it allows me to sell $2 wide spreads.

Choosing the right strike prices

My credit spread trading rules for selling are to find a short strike with a probability of expiring (ITM) between 30 and 35%. This means a probability of expiring worthless of between 65 and 70%. That's really the sweet spot for this kind of trade since it offers a decent price on the spread and a decent probability of success.

In addition, I want to sell this spread with at least 20 days until expiration (but less than about 40). February has only 10 days left and March has 38. So... March it is!

Credit spread strike selection

Before the market opened, I was looking at the $102 strike but that quickly dropped to near 30% probability of expiring at the open. As a result, I sold the $103 and bought the $101 as the other leg. This $2 wide spread was trading at $.46, which is a pretty good price.

Risk/Reward analysis

With a $.46 credit on a $2 spread, that means I'm risking about $1.54 of my own money on the trade. That is... if I let the trade go to the maximum loss.

As those who have followed these trades know, I rarely let a trade go all the way to maximum loss. However for analysis purposes, it's a good idea to know.

If I were to face the maximum loss, then my reward/risk ratio would be 29.8% (almost 30%). That's not really great unless I win on my trades a lot more than I lose. With a probability of success of at least 65%, that at least helps. 

The alternative is to further limit my risk. One way I can do this is to determine an early exit plan. With the credit spread trading plan, one of my exit rules is to close the trade when I stand to lose an amount equal to the credit I received. That means if I took in $.46 in credit, then I'll exit when the cost to close is $.92, which means I give back the original credit and I give up an additional $.46 of my own money. 

With this kind of exit, I now have more of a 100% reward/risk ratio. That coupled with a better than 50% probability of success should mean I make money over the long term right?


My other exit rule for a credit spread is to close the trade when I can lock in 80% of the credit. That means best case, I'd only keep about $.37, but I'd still be potentially risking $.46 so in this case, my reward/risk is 80%. That's still really good.

I have one other ace up my sleeve on this trade. I'm employing a little technical analysis to help me make an early exit in case I'm wrong about the bounce. What would tell me I'm wrong is if the SPY closed below the prior low, making a lower low. That would indicate there's more selling. There's a good chance that that exit might trigger me out of the trade even before the other exit rules.

Position sizing

In position sizing, I start with my portfolio, which currently stands at about $18,500. I always risk about 2% of this on each trade. That means about $370 risked for this trade.

If I know I'm limiting my risk to $.46/contract then how many contracts can I take?

370/(.46 * 100) = 8

I mis-calculated this morning and only put on 7. I'll try to get another contract on in the morning.

Why? Because it's important to keep the amount risked roughly equal. Since there is no way to know for sure which trades will succeed and which will fail, keeping the risk amount roughly equal is the best way to maximize my potential gain on any one trade while minimizing my potential loss on the same.

Exit plan

I've already mentioned several of my exits, which relate to my risk and reward. And, of course, I also have my technical exit, which I've also discussed.

The final rule I have regarding exits is to make sure I'm out of the trade within 4-5 days. Most of these are the same rules I follow on every credit spread trade.

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

  1. I will exit when I can do so for $.09, locking in 80% of the credit of $.37
  2. I will exit when it costs $.92 to close - I want to limit my loss to $.46
  3. I will close if SPY closes below $105 (actually about $104.50)
  4. I will exit when approximately 4-5 days of expiration

With a platform like Thinkorswim, I can ensure I automatically ensure that the first two rules are implemented whether I'm at my desk or not.

Credit spread closing orders

This is a one-cancels-other (OCO) order. This order goes in and all I need to do is sit back and let time pass. In this case though, I will also be monitoring for the technical exit.

Portfolio Impact

Until, yesterday, I had a fairly bearish portfolio. However when I closed the call spread, I was left with a fairly neutral calendar spread. 

Credit spread portfolio impact

With this bullish credit spread, the portfolio is now much more bullish. If we see a strong move up over the next few days, I may want to balance this out somewhat with a few call spreads.

The key here is to continue to add theta producing trades while keeping the portfolio biased in the direction of my forecast.

Update 2/16/2010

With the market bouncing somewhat, I'm looking at starting to add some negative delta to this position.

SPY credit spread review

There is a possibility that the SPY will continue its upward move and push through the 111 level. There is also a chance that there will be some selling to take profit. With that in mind, I decided to add a few contracts of a call credit spread. I sold 2 contracts of the 114/112 call spread for a $.61 credit (total $122). The nice thing about this trade is it doesn't require any additional margin. I now effectively have a 2 contract iron condor.

By the way, the put credit spread is not too far from being ready to close. I have about $.16 more to erode away and I can close that side.

Update 2/252010

This last week has been a bit of a wild ride. With the sell-off, I saw a bit of my profit being given back. However, with the recent bounce, this trade now only has about $.04 left. I closed part of the trade early just to make sure I don't give back any profit again. I purchased back 4 contracts for $.14 leaving 4 more contracts to run.

This illustrates a trade management technique that I'll be discussing more in my next newsletter.

Update 3/3/2010 (closing update)

I closed the remaining puts Monday morning with the strong gap up first thing in the morning. I closed the remaining 4 contracts for $.09 debit. That makes the average closing debit for the put vertical spread $.115.

This morning, I closed out the call spread. I am taking a small loss on that part of the trade because I believe the market in general is showing enough strength that it's time to get out. I entered the trade for $.61 (with 2 contracts) and paid $1.03 to close it out. That's a $.42 loss on two contracts. If I were to equate that to my 8 contract spread, that would be $.105 per contract.

That makes my net debits $.22 (.115 + .105). I received an initial credit of $.46 so my net profit is $.24. That makes a total profit on this trade of $192.

You may be wondering why I didn't just leave the trade alone and let it work. Well, hindsight is 20/20 but I'm wondering that myself now. I had initially suspected that the bounce would fail at around $111, which it initially did. However, just a few days ago, the SPY pushed up through $111, although gently. For a few days, I was actually right that the bounce would fail.

The truth is that sometimes it's hard to just let a trade alone when it's doing well. It's tempting to read the market and decide to make a trade. On the other hand, I could have been right about the move - in which case, this trade would have had an additional profit. It's a chance you take. I believe that trade could have stood on its own and still would have lost. I'm just glad it didn't lose as much as it could have.

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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