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Trade of the Week - Put Credit Spread (3/17/2010)

I'm beginning to become a bit more bullish as evidenced by this credit spread I'm putting on.

Credit spread trade setup

Sell DIA 105/103 put spread
1. Exit if I can lock in 80% of my initial credit (i.e. $.08)
2. Exit if cost to close >= twice initial credit (i.e. $.80)
3. Exit if within 4-7 days of expiration
Credit $.40

This is again a $2 wide credit spread on the SPY. It balances out my portfolio and is in keeping with my more bullish posture.

Why this strategy?

Most of the industry wide indices have broken out to new highs in the last week or so. Up until this point, I was a little more neutral but I do think now that we may be entering a new bullish phase. Yet... the move is also a little bit extended, which means that a pullback could be coming any time soon.

Put credit spreads are good trades when you are mildly bullish to even neutral as long as a good position can be had. In this point, I'm looking at a position that is at or below the most recent support bounce around $115.

Choosing the right strike prices

While I have a technical price in mind, I typically choose my short strike by looking for a option that has around 35% probability of expiring ITM by a penny or more. The closest option is the $105 strike.

Credit spread strike selection

I typically trade $2 wide spreads on these ETFs. However, I did a quick analysis of some different spreads. It's not a bad idea to ask this question from time to time. Here's what I came up with.

Spread Credit # contracts Commission
(Assume $1.50)
Net Credit
$1 $.22 4 $12 $76
$2 $.40 2 $6 $74
$4 $.67 1 $3 $64

With a $1.50 per contract commission, the $1 spread is the best value, although not much better than the $2 spread. I still went ahead with a $2 as it gives me some flexibility and does save a few dollars in commission.

I'm looking at April options since there is still 30 days until expiration. The March options will expire this Friday and then the April options will begin to accelerate in their time decay.

Risk/Reward analysis

With credit spreads, I typically have two different ways of looking at risk. There is an absolute risk in this trade of $2 per contract minus the credit I received. That means an absolute risk in this case will be $1.60 per contract.

The other way to look at the risk is the max loss amount I will allow based on my trading rules. With this trading plan, I usually exit when the cost to exit is twice my credit. That would be a $.80 exit price and a $.40 risk. Obviously, this risk amount is less than the absolute risk and would allow me to take more contracts in my position. However, this strategy will also require an absolute adherence to my exit rules.

Position sizing

My current portfolio is about $18,500. As in all my trades, I'm risking 2% of that portfolio on each trade. That means I can risk $370 on this trade. If I go with my typical exit plan (2x the credit), then my risk per contract in this case is $.40, or $40 per contract. That means I can take 9 contracts.

Exit plan

With this credit spread trading strategy and trading plan, I have a pretty standard set of exits. I will exit under the following conditions.

  1. I will exit when it costs $.80 to close, which limits my loss in the trade to $40 per contract or about $360
  2. I will exit when I can do so for $.08, which allows me to lock in 80% of the credit, which would be $288
  3. I will exit when approximately 4-5 days of expiration

On the Thinkorswim platform, it's pretty easy to make sure my first to rules are followed automatically. I simply create a 'One Cancels Other' order and set up one as a limit order to close at $.08 and the other as a stop order with a trigger price of $.80.

Credit spread exits

Portfolio Impact

This trade is a positive delta, positive theta trade. This is exactly the kind of trade I'm looking for and the result is that my overall portfolio is now more bullish.

credit spread portfolio impact

I'll be continuing to monitor the market and adjust my portfolio in keeping with my outlook.

Update 3/25/2010

This trade has turned out to be a good choice and a nice addition to the portfolio.

The market continues to exhibit ludicrous bullishness and that has made this trade quickly gain in value by causing the cost to close to drop. At this point, I could exit the trade for around $.22, which is about 1/2 the initial credit and only about $.14 away from my target exit price.

If the DIA continues to make a stronger run up, I may take a contrarian position by adding some calls. I'd prefer to be selling above the prior congestion area from back in the July, Aug, Sept 2008 timeframe.

Do you realize that the DIA is almost ready to to break above the area where the market plummeted in the fall of 2008? The NDX (QQQQ) has already broken some of those levels.

I'm starting to expect another pullback just because of the prolonged run we've had.

Update 4/2/2010 (Closing summary)

Right on the market open yesterday, the DIA (along with the rest of the market) gapped up causing the remaining premium to drain out. As a result, this position is now closed at $.08 debit.

This turned out to be another textbook trade. In this strongly bullish market, these vertical spreads have performed well. Let's take a look at the trade.

I put the trade on for $.40 credit and closed for $.08 leaving a net profit of $.32. That's an ROI on the trade of about 20%. The way I calculate that is to divide .32 by the initial margin amount of $1.60.

Since I sold 9 contracts, my absolute net profit was $288. When I put this trade on, my portfolio was about $18500 so my portfolio return is 1.5%. That's a pretty good return and right in the range of target profit for each trade.

If all of these credit spread trades are doing so well, why not just trade them and forget all the other strategies? The reality is we don't know what the future of the market is. We always make decisions off the hard right edge of the chart. As a result, it is beneficial to have a mix of strategies in our portfolio. Some will do well and some will lose a little but the net result should be an account that grows month after month.

Trading all one strategy can work well as long as the market does the same thing day after day. Once a change happens, a series of losses can wipe out all the gains made by all of the prior successful trades.

I happen to like the credit spread as a strategy. Overall, I tend to have more of these in my portfolio than anything else. But I also like to have some "just in case" strategies as well. It may be time to think about a put calendar spread "just in case" we see a pullback or an iron condor "just in case" the market decides to become range bound.

The key thing is to enter good trades for good logical reasons. By that, I mean trades that are premium selling that can make money even when I'm wrong that are put on for sound technical reasons.

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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