Trade Tutorial - Put Credit Spread (3/26/2013)

I'm going to enter this put credit spread as one more shot at capitalizing on the strength of the market.

Credit Spread trade setup

Trade
Sell DIA 143/141 put spread
ROI
22%
Exits
1. Exit if I can lock in 80% of my initial credit (i.e. $.07)
2. Exit if DIA falls below $143.50
3. Exit if within 4-7 days of expiration
Credit $.37

It might seem a little early to be taking a bullish trade given that we're currently in a consolidation period and bumping against the resistance. Let's see why this trade might make sense.

Why this strategy?

Why enter a bullish trade at the end of a bullish run and at a point when it appears that the market is consolidating? Because one of the things that often happens following this kind of move is a breakout above the consolidation and resistance area. Since a credit spread is a reasonably short term trade, this is the kind of strategy that can profit even we see another week of consolidation and a relatively minor push above the overhead resistance.

Now, this is of course a somewhat speculative trade. However, I have a clear idea of whether I'm wrong on the trade. For example, if we were to see the DIA fail and fall down through the consolidation area below $143.50 or so, that would probably be a good technical indicator to exit the trade or adjust into a bearish type trade.

Choosing the right strike prices

My typical trading plan for the credit spread strategy is to look for a option month having 20-40 days until expiration and a short strike with a probability of expiring OTM of between 65 and 70%. That means I have an overall trade with a probability of success of at least 65%.

Credit spread strike selection

At the time of entering this trade, the April option cycle had 24 days until expiration and the $143 short put was right at 65% probability of expiring OTM. For my long strike selection I have been in the habit of building $2 wide credit spread positions. As a result, that means I will have the $143/141 put spread, which I can sell for a credit of $.37. Now, that's not as much as I'd like or as much as we've been used to getting. The problem is that volatility has gotten so low that the associated premiums have been low as well.

Risk/Reward analysis

I have a $2 wide credit spread that I can sell for a $.37 credit. That means that my total risk in the trade is $1.63 (2 - .37). If I simply let the trade go until expiration, my reward/risk ratio is the max gain divided by the risk or .37/1.63 = 22%. That's an ok reward/risk ratio given that the probability of success is around 65%. I'd like it to be higher but again, it's just a product of the lower volatility that makes premium selling a little more difficult.

Most of you probably already know that I don't let the trade go all the way to expiration. I have a typical exit rule to close the trade if I can lock in 80% of the credit. As a result, my max gain will actually only be about $.30. That means my reward/risk ratio with this approach is only about 18%. However, my probability of success is now actually higher as well because I'm not holding onto the trade to get the last $.01 out of the credit. By being willing to close sooner, I improve my chances.\

I've been asked about this quite a lot as to why I exit early. This is my main reason is that I've found that holding on for that last percentage, which usually amounts to $.05-$.10 puts any gains the trade may have achieved at risk. Not only that, but at any time while the trade is open it could experience maximum loss. There's nothing worse than having a trade where you have 80% of your target gain on the table and watching it turn into a full loss. That's the main reason I do that.

Position sizing

Now that I know my risk in the trade, it's easy to calculate my position size. Most readers of these tutorials know that I only risk 2% of my portfolio in any one trade.

I can't stress enough the importance of reasonable, consistent money management. If there is anything that will drain a trader's account quickly, it's over allocating trading capital to any one trade.

As a result of my 2% plan, I simply allocate 2% of my portfolio value, which is currently $17,374. That means I can risk just $347 in the trade. Since my risk in the trade (per contract) is $163, that means I can only sell 2 contracts and remain within my risk threshold. As a result, my target gain for this trade will be $60 (.3 * 2 *100).

Exit plan

I've already talked about my exit rule to close the trade when I can lock in 80% of the credit. That means that I will place a limit order trade to buy back the spread when the price reaches $.07. In addition, I mentioned earlier that I would also use a technical indicator to either close out of the trade when the DIA falls below a certain level or adjust. I think the wisest course here is probably to simply close the trade and look for a new one if that happens. A good level to indicate the bullishness has failed is if the DIA falls below $143.50, which is below the lowest point of the consolidation.

I can enter this on the thinkorswim platform by using an OCO order. Check with your broker to see if this is possible before planning exits like this.

In summary, I will exit under the following conditions.

  1. I will exit when I can do so for $.07 debit. That allows me to lock 80% of the credit or $.30.
  2. I will exit if the DIA falls below $143.50, which represents a current support area for this recent consolidation.
  3. I will exit when approximately 4-5 days of expiration

Portfolio Impact

At the moment, this is the only trade that I have open so it's no surprise to see a positive delta. This indicates two things. First, that the trade will benefit from an increase in the price of the underlying (DIA). Second, a positive number is a quick way to note that this is a bullish trade. From a consolidated portfolio perspective, this is a good way to see what bias your overall portfolio has.

Credit spread portfolio impact

Given that my trading strategies are generally always premium selling strategies, I expect to also see positive theta in the position as well. As we can see above, the theta is positive and indicates that every day that passes (all other things remaining the same) the position will gain $.89 in value. A combined bullish move and many days passing will cause the trade to profit more quickly.

Update 4/10/2013 (closing update)

This trade closed after the market rocketed up to even higher gains. The good news is that this is a profitable trade!

My order to lock in profit has worked out exactly as expected. With the market powering up to even higher highs, this credit spread closed at the target $.07 debit. So how does that leave this trade? I entered for a credit of $.37 and closed for a debit of $.07. That makes my net profit $.30 per contract of $60 total.

This trade worked out pretty much as expected so there's not too much to say regarding lessons learned. However, the one point I'd make is that consistency is the key to seeing these trades work out. Having a set of rules consistently applied for entry and having consistent rules for exit is what makes this strategy work. Of course there will be losing trades (as my last one was) but over all, the gains are steady.

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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