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Trade Tutorial - Put Credit Spread (3/5/2012)

It's time for a bearish credit spread. I said in the last newsletter that I would wait for the market to tip it's hand had it looks like it did...

credit spread trade setup

Sell DIA 134/132 call spread
1. Exit if I can lock in 80% of my initial credit (i.e. $.12)
2. Exit if DIA establishes higher high (> $130.40)

3. Exit if within 4-7 days of expiration
Credit $.62

Why this strategy?

In the last newsletter, I said that I was uncertain as to which forces might ultimately win between the tension to pull the market up to higher highs or the force that exerts itself to pull the market back to its 30 day moving average. We started to see this indication this morning when the market opened lower. While there has been a rally toward the end of the day, I still think this is the indication of weakness that tips my bias a little more short term bearish.

When I say short term, I mean in the next few weeks. It wouldn't surprise me to see some selling down to the 30 day MA or even the 50 day MA. I could even see selling down to the support level near $126 area. As a result, I'm looking at a call credit spread, selling above the recent highs.

Choosing the right strike prices

First, I want to point out that one of the recent changes of the thinkorswim platform includes breaking out probability of expiring, which used to mean probability of expiring in-the-money by a penny or more. If you wanted the opposite probability (the probability of expiring out-of-the-money), you had to do the math. We typically look for that number because it can be thought of as the probability of success for many of the premium selling strategies.

For the credit spread strategy, I typically look for a short option that has an approximate probability of expiring OTM of between 65 and 70% in an option month having at least 20 days until expiration.

credit spread strike selection

Notice above, I'm looking at options in April and I've gone with a slightly higher probability of expiring OTM. Part of the reason I'm doing this is that I still believe there is a slight up side risk. The other reason is due to the fact that I can still get a decent credit on this trade. I'm always trading off probability of success with potential profitability of the trade.

As with nearly all my credit spread trades, I will buy an option $2 farther OTM creating a $2 wide spread. I've entered this trade for a credit of $.62.

Risk/Reward analysis

I have a $2 wide spread for which I received a credit of $.62. That means the absolute most I can lose in this trade is $1.38. That is enough for me to calculate the reward risk. I simply divide my reward amount by the risk amount and arrive at a percentage of 45%. This can also be considered my absolute return on risk.

Those that have followed my credit spread tutorials probably know what's coming next. I almost never allow a trade to go all the way to expiration. There are lots of reasons for this that I've covered on the credit spread (vertical spread) strategy page as well as in recent newsletters. As a result, I will close the trade when I can lock in 80% of the initial credit. That means my target return is actually $.50. However, my risk remains the same. As a result, my actual return on risk is projected to be 36%. That's still a great return and comes with an increased probability of success.

Position sizing

In every trade I take, I never risk more than 2% of my current portfolio value. This portfolio currently is $17,407. As a result, I can only risk $348 in this trade. Since I already know my maximum risk in this trade, it becomes very easy to determine how many contracts I can sell. If I take the total risk ($348) and divide by risk per contract ($1.38 * 100 = $138) then I find I can sell just 2 contracts and remain within my risk tolerance.

Exit plan

Taking a bearish trade in the midst of a longer term bullish trend can be a bit of a risky strategy. The risk is in the fact that this current weakness could in fact be short lived. As a result, I'm going to add an exit rule that will help protect me in the event I'm wrong in my assessment. A good rule would be to close the trade if the DIA reaches a higher high, which was established back on Feb 29 at a level of $130.37. So, I'll make an exit rule that if the DIA reaches a level of $130.40 (just a little higher), then I'll close the trade at market.

In the past, I've mentioned that it can be difficult to catch this kind of situation if you aren't at your trading station or if you tend to waver in your decision to execute on your rules. On the thinkorswim platform, it is quite easy to set up a closing order to close the spread (at market) when the underlying reaches a certain level. The following screen capture shows the basic steps.

credt spread early exit

In addition, I mentioned that I will also close the trade when I can lock in 80% of the initial credit. This represents the best case scenario. In order to make sure both rules can exist for the same trade, I'll set up a one cancels other (OCO) order.

To summarize all my exit rules, I will exit under the following conditions:

  1. I will exit when I can lock in 80% of my initial credit. That means I will close for a debit of $.12 leaving $.50 net profit per contract for a target trade profit of $100.
  2. I will exit if the DIA establishes a higher high by exceeding $130.40. The impact on risk is difficult to know ahead of time but will never be more than $1.38 per contract or a total trade risk of $276.
  3. I will exit when approximately 4-5 days of expiration

Portfolio Impact

For the first time in a while, I actually have more than one trade on at a time. As a result, it's important to understand the interaction of these two trades. As you would expect, a bearish trade like this call credit spread would add negative delta to the position. Because of the selling in SPY, the iron condor trade currently has a positive delta. The result is a lower positive delta due to the impact of adding this call spread.

credit spread portfolio impact

The nice thing about this kind of trade is that it adds theta to the overall position, which means an increase in the amount of money made simply as time passes due to the time premium portion of the options melting away. This represents a good overall portfolio position to hold right now.

Depending on how the market shapes up over the next few days, I may add an a bullish position. I'd like to see some support established first though.

Update 3/13/2012 (closing update)

That was a pretty short trade. I was reasonably certain that the market would take a pause before pushing higher and it turns out I was wrong. That's why that stop loss order was in.

Let's see what the impact was. Remember, I had an OCO (one-cancels-other) that would either stop me out if the DIA exceeded $130.40 or if I could close the spread for a debit of $.12. The stop loss order turned into a market order to buy back the credit spread at any cost when the DIA crossed $130.40. The actual cost to close the spread was $.66. That turned out to be a fortunate result since I sold the spread for $.62. That means my net loss was only $.04, times 2 contracts or $8.

I want to wrap up this trade by summarizing my assumptions going and and how that affected my exit rules. I knew that in an upwardly trending market there was a risk to the up side. That was the reason I put a stop loss trigger based on price of the underlying. In other words, this trade was either going to go as expected and the underlying would sell off, allowing me to close the credit spread for my target profit OR the market would push to new highs, in which case I'd close the spread for a loss less than the max loss.

It's about capital preservation. There's no reason to stay in a trade when you are clearly wrong and this particular trade setup had obvious indicators to tell me if I was wrong. I'll simply walk away from this trade and look for another good setup.

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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