Trade of the Week - Put Credit Spread (2/24/2010)

This is another put credit spread on the EWZ. I have been hesitating on putting on a trade due to my uncertainty. I put the trade on yesterday morning when there appeared to be a bounce forming. This morning as I finish writing this summary up, it looks as if I may have been premature. I'll give the trade another day or so to see what happens.



Trade
Sell EWZ 65/63 put spread
ROI
29%
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. $.90)
3. Exit if within 4-7 days of expiration
Credit $.45

This is a $2 wide spread, with a fairly decent probability of success. That said, these are uncertain market times so I'll be keeping this trade on a short leash and may close early if warranted.

Why this strategy?

I chose this strategy for two reasons. First, it appeared that the recent selling was over as EWZ started to bounce. With the selling and rise in volatility prices of the spreads have improved. The put credit spread is a great strategy when the outlook is bullish and there's a little bit of inflated volatility.

EWZ has a history of making dramatic swings as the broader market is making smaller moves. With EWZ approaching the 200 day moving average, there is a chance this will act as support.

Choosing the right strike prices

As per my trading plan for the credit spread strategy, I'll look to sell a short strike having a probability of expiring between 30 and 35%. That yields a trade with a probability of success between 65 and 70%. In this case that's a short 65 put.

I tend to trade $2 wide spreads a lot. I like the price I get for them and the risk is limited then to that spread minus the credit. That means I'll buy a 63 put.

As I look at the option chain, I notice that today is really the last day to take a trade in March and still have 20 days to expiration. I chose to sell options with at least 20 days until expiration because there's still enough time premium to make a good trade.

Risk/Reward analysis

I have a $2 spread that will yield $.45 in credit to sell. That means my max loss amount could be as much as $1.55. That means I will need to put up $155 per contract in margin and represents the amount I could lose if this trade goes completely against me and I let it go until expiration.

That means I have a reward to risk ratio of $45/$155 or 30%. This also represents my ultimate return on investment since I have to put up $155 of my money to realize the $45 maximum reward.

Position sizing

I mentioned above that the maximum risk on the trade is $155. That doesn't mean I have to let the trade go all the way to the worst case. Those who have followed previous credit spread trades know I have three built in (automatic) exit rules. One of those rules determines when I'll exit if the trade goes against me. I set a rule to exit when I stand to lose an amount equal to the credit I receive.

In this case, that means my risk in the trade is only $45 per contract. I'm currently risking 2% of my portfolio per trade, or $376 (based on the current portfolio of around $18,000). That means I can take 8 contracts and remain within my risk allotment.

Exit plan

As I mentioned, I have a number of built in exit rules as part of this strategy. I'll outline them below. Given the nature of the market right now, I am also going to have an additional exit rule. I entered this trade because I believed there would be a bounce that would continue and perhaps push up over $70. However, a close below about $65 would perhaps indicate that this bounce is a failed bounce. The $65 area right now is an area of prior support. If this support fails, I'll know I'm wrong and should be exiting this trade.

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

  1. I will exit when it costs $1.15 to close - I want to limit my loss on the trade to $150 (in case you're wondering that price is $.40 + .75)
  2. I will exit when I can do so for $.05 - I want to give a little more profit room in the trade, especially if it makes a move to the up side
  3. I will exit when approximately 4-5 days of expiration
  4. I will exit on a close below $65

One way to make sure that at least my first two rules are followed even when I'm not at my computer is to set up some mechanical exits using my trading platform.

On the Thinkorswim platform, I can set up an OCO order that will handle both orders at the same time. One order will exit me out when I can close for $.09 and lock in my target profit. The other order will stop me out when it cost me twice my initial credit.

Portfolio Impact

This put credit spread trade is a bullish one that adds positive delta. As a result, the net delta is lower that before and yet... it adds positive theta. As a result, it accomplishes both my objectives in putting this trade on.

I will be continuing to monitor the market. As my bias (bullish or bearish) changes, I'll be adjusting my delta accordingly and adding theta all the while.

Update3/5/2010

Just over a week after putting this trade, on, most of the value has evaporated out of this position, which is good for this credit spread.

There's just $.09 left to evaporate until I hit my target exit. With a weekend coming up and a potential resumption of the rally, this exit could come as early as next week.

What are the other potential outcomes? This pause could turn into a sell-off. If that's the case, my current profit could disappear. At what point would I consider exiting early? One of the support levels right now is $70, which was a former resistance level. I don't know that I'd get out that early. There is another support level at $65. I'm thinking that would be my trigger to exit.

While this eventuality may never happen, it's always a good idea to have a plan if the worst happens.

Update 3/6/2010 (Closing update)

Before I even had a chance to post the earlier update, this credit spread trade triggered an exit with my target profit point.

I closed the trade for $.09, which means my net profit is $.36. That's a 23% return on my margin. Also, that's a 1.6% return on my portfolio. That's a pretty decent return for this trade. Overall, this was a pretty short trade. I think it lasted less than 2 weeks. It's great when a trade works this way but it doesn't always. I'm thankful for this one and so, it's on to the next trade...

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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