Trade of the Week - Put Credit Spread (2/24/2011)

I think it's time for another credit spread. Take a look at the latest trend in the DIA.

Credit spread trade on DIA

Trade
Sell DIA 119/117 put spread
ROI
28%
Exits
1. Exit if I can lock in 80% of my initial credit (i.e. $.09)
2. Exit if within 4-7 days of expiration
Credit $.44

We may be looking at a good entry opportunity - or a fake out. Taking a risk is the price of entry. Managing that risk is the price of staying in the game.

Why this strategy?

The market in general has been in a strong bullish trend. The last few days have seen a nice little 3% pullback on the DIA. Not surprisingly, it looks like the DIA found support at the 30 day moving average.

Given that I'm looking at a bullish trade, there are a few choices available to me. The key things to consider are targeted timeframe, risk tolerance, and capital available to risk. I'm looking at a fairly short timeframe since it's not clear this move will result in a break over the recent highs. Also, with the recent debit trade on the SPY calendar spread, I'm not really looking to enter a trade that requires a large investment.

That pretty much leaves a credit spread, which has a relatively short trade duration and a relatively small margin requirement. I always like to have at lest one of these trades on at any given time.

Choosing the right strike prices

The trading plan for my credit spread strategy calls for looking for a short strike having 20 days or more until expiration and a probability of expiring ITM of between 30 and 35%. At this point, we still have a few days left in the March options cycle.

Credit spread strike selection

In this case I'm looking at a probability that's slightly higher than the 35% upper limit that I outlined in the trading plan. However when I was looking at this trade, the market was on the move. Just a short time later this percentage was more like 35%.

Risk/Reward analysis

The credit for a $2 wide put credit spread with the short strike at $119 is $.44, which means the risk in this trade is $1.52. That means my reward/risk ratio is 28%. That's a fairly decent return on this kind of trade.

I've mentioned in past trades that there are many ways of managing credit spread trades to optimize the reward risk. However, as we've seen over the last year, gaining a higher reward/risk comes with a trade-off of lower success rates.

Position sizing

My trading rules for all my trades call for limiting my trade risk to just 2% of my current portfolio value, which is $16,856 at the moment. That means I can risk $337 on this trade. With a risk of $1.54 I can sell just 2 contracts and remain within the risk tolerance I've outlined.

Exit plan

With this kind of position sizing approach there's no need to define an early exit rule to ensure I remain within my risk limits. However, there's no point in being careless with the trade. The current low of the DIA is right at $120, which is currently the point of the 30 day moving average. I'd say a close below the low formed today would be a reasonable trigger to exit.

It's reasonable to assume that if a lower low forms that this will represent a change in trend.

So, just to summarize... I will exit under the following conditions.

  1. I will exit when I can do so for $.09, which represents an opportunity to lock in 80% of the initial credit.
  2. I will employ a technical exit to ensure that the trade doesn't get too far out of hand.
  3. I will exit when approximately 4-5 days of expiration

Last time I mentioned a technical exit, I forgot to watch it. My recommendation at the time was to make use of an alert. Most trading platforms have an alert mechanism to send a notification if the underlying falls below or rises above a certain price level. If yours doesn't consider switching to thinkorswim by TD Ameritrade.

Portfolio Impact

The existing trade I have on (the SPY calendar spread) is a bearish trade that has a slight negative delta. Not surprisingly, this trade adds positive delta to the portfolio.

Credit spread portfolio impact

Notice both trades currently add positive theta, which means the portfolio as a whole benefits from the passage of time (assuming no other changes.

We'll continue to monitor this trade to see how it progresses. With a continued move up, I may look for a call credit spread to balance out the delta and create a more neutral position.

 

Update 3/21/2011 (closing update)

I probably should have closed this trade as planned since we had a break of the $120 level about a week ago.

That said, it did give me an opportunity to test and illustrate the value of this kind of trade. Here's how the trade worked out.

credit spread trade exit analysis

I entered the trade for a credit of $.44. Due to the rally on Thursday and Friday of last week (expiration week), I was able to close the trade for a debit of $.37. As a result, the trade realized a $.07 profit. Since I sold 2 contracts, the trade itself realized a profit of $14.

As part of this summary, I want to conclude with two thoughts. First of all, I should have exited the trade as planned since I had a rule to close the position if within 4-5 days of expiration. However, at that point, I had nothing to loose as the trade was near maximum loss. This leads to the second point, which is that it really was the flexibility to allow this trade to go to maximum loss that enabled me to take the trade to the absolute limit. Had this credit spread been something less that a total loss, the decision might have been to close sooner at some amount of loss.

I was hoping for an opportunity to demonstrate the value of being able to allow the trade to full loss and this was the absolute extreme example.

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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