Trade Tutorial - Put Credit Spread (3/25/2011)

I think it's time for another put credit spread!

credit spread trade on IWM

Trade
Sell IWM 81/79 put spread
ROI
25%
Exits
1. Exit if I can lock in 80% of my initial credit (i.e. $.08 debit)
2. Exit if within 4-7 days of expiration
Credit $.40

The market seems to have gotten over it's generally news driven fears, which may provide an opportunity for a bullish trade such as this.

Why this strategy?

The market overall has begun to establish a short term bullish trend after breaking through short term resistance levels. While we're not out of the woods yet, I still think it's a good opportunity to put this credit spread trade on.

As I've been attempting to do recently, let me go over my choices for bullish trades.

  • Put credit spread - Shorter term trade with plenty of wiggle room to be wrong and still be successful. Not as profitable as other trades.
  • Naked put - I don't do these very often and I only will if I'm willing to potentially own the underlying. Also a shorter term trade but carries a larger margin requirement.
  • Call diagonal spread - a bit longer term trade with a larger up side potential
  • Call debit spread - the companion of the put credit spread but allows me to potentially take a bit more of an aggressive position. I'll sometimes use these when I'm a little more bullish near term.

Of these choices I am selecting the credit spread because it fits my outlook for the next 3 weeks. I'm not quite ready to take on a more long term bullish trade. This position nicely compliments the remainder of the iron condor trade that just had it's put spread closed.

Choosing the right strike prices

I usually look to sell a short strike in an option month having at least 20 days until expiration and having a probability of expiring (ITM) of between 30 and 35%.

credit spread strike selection

In this case, I selected a short strike of 81. Since I trade $2 wide spreads, my long strike will be $79. The position sold for $.40. That credit is just about the minimum I'd want to get in order to make the trade compelling. Interestingly, I recently attended a free trading workshop offered by TD Ameritrade but given by one of the thinkorswim guys. He actually recommends 30-50 days until expiration. The one advantage to this is the options will have a little more time premium left in them.

Risk/Reward analysis

Since I'm receiving a credit of $.40 on a spread of $2, my risk in the trade is $1.6. That's pretty much a 3:1 risk to reward. Put another way, I'm forced to put up $1.60 of my own money for a potential reward of $.40. That means my return on risk is 25%.

That's not great but not terrible either given the probability of success the trade has. Remember, I chose a short strike having a probability of expiring of about 35%. That means it has a probability of expiring worthless of 65%, which is the goal of this trade.

Position sizing

Since I know my risk amount for this trade (per contract), it's an easy matter to determine how many contracts I can safely sell. My current portfolio is worth about $17,572. Since I risk only 2% per trade, I can risk just $351 in this trade. Since my risk per contract is $160, I can safely sell 2 contracts.

Exit plan

For now, I'm going to only go with two rules for exiting this trade. One rule is to lock in my profit at 80% of the initial credit. As I've explained many times, I prefer to close before expiration. For a quick summary, register to receive the monthly newsletter and check out March's back issue.

Just to summarize,

  1. 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
  2. I will exit when approximately 4-5 days of expiration

Portfolio Impact

I put this trade on at an interesting time. The same day I put this credit spread on, I closed the put spread on my iron condor trade on the SPY. Prior to adding this position, that left my position with a sizable negative delta.

By adding this position in, I've compensated somewhat and done so with an underlying instrument that shows more relative strength. Notice in the process I've added more positive theta to the position.

Update 4/6/2011 (closing update)

Well, that didn't take long. This trade closed yesterday with the limit order I had in place.

Let's quickly summarize the results of this trade. I sold 2 contracts of this position at $.40 and closed the position for $.08 (locking in 80% of the initial credit). That means I realized a profit in this trade of $64. Given that my risk in this trade was $320 ($160 x 2), my return on risk is 20%. Not bad but not great either. While that doesn't seem like a lot, remember that I'm taking smaller position sizes in order to allow me to stay in trades longer.

So far, this strategy has paid off. The only lesson I can draw from this trade beyond validation of the new position sizing and exit rules is that perhaps I should have looked at the next month out to place this trade given the fact that it yield a fairly small return. The initial credit on a trade with more time would have perhaps yielded another $5-10 per contract in profit but would have taken longer to close.

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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