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Trade Tutorial - Call Credit Spread (4/4/2013)

I got this call credit spread in just in time (apparently). I had said in the newsletter that I would look for an opportunity to maybe sell at the top of the market. We'll see if this is the one.

Credit spread trade setup

Sell DIA 150/148 put spread
1. Exit if I can lock in 80% of my initial credit (i.e. $.05)
2. Exit if DIA makes a higher high ($146.50)
3. Exit if within 4-7 days of expiration
Credit $.55

This trade is a little bit of a shot in the dark. A day later as I write this up, it does appear like there may have been a top with some new selling. Yet - time will tell.

Why this strategy?

I said in the the last newsletter that I was expecting a possible top to form that may offer a chance to sell a call spread. It's hard to tell but DIA poked its head above the 161% fibonacci retracement level (a somewhat important projection point for any follow through retracement that breaks over the 100% level).

As a result, it seems like now would be a good time to sell a call spread. I had originally planned to sell a spread in the same month as my put spread trade. However, there isn't enough time remaining in the April cycle (see strike selection below).

Why DIA? If you look at the DIA compared to IWM and SPY, you'll see that DIA has made a more extended move. As a result, it is likely that DIA will experience more of a sell-off if one occurs.

Why a credit spread? Remember in the newsletter, I said that any trades should probably be short term trades. I doubt any selling will be long term so it's probably not a good idea to make any long term trades until a trend establishes itself.

Choosing the right strike prices

As mentioned above, I had originally intended to use the call credit spread to be added to my previous put spread to create an iron condor. However, there just isn't enough time in the April cycle. My goal is to sell in an option cycle having 20-40 days until expiration. I'll err on the side of more time before I'll settle for less time just because of the lack of premium.

Credit spread strike selection

As a result, I went to the May option cycle for selling the spread. My usual strategy is to sell a short strike having a probability of expiring (OTM) of between 65 and 70%. However, I find call spreads often have a bit richer premium so I'm willing to slide that as well. The $148 strike has a probability of 70.65%, which equates to a 70% probability of this trade being successful.

In terms of selecting the long strike, I'll usually sell $2 wide spreads so I'm looking to buy the $150 strike to go with the $148 short strike. I've been asked about $1 wide spreads in the past. Check out some of the past newsletters for answers to your questions for an extended discussion of this.

I can sell this $2 wide spread for a credit of $.55. As a result, I have a $1.45 risk in the trade.

Risk/Reward analysis

Now that I know my max gain and max risk, we can calculate the risk and reward ratio. I usually put in terms of reward/risk or return on risk percentage. This is calculated by dividing the max gain by the max risk so $.55/$1.45 = .37 (or 37%). Of course, this assumes I let the trade go all the way to expiration.

Most followers of these tutorials know that I don't let the trade go all the way to expiration. Instead, I'll look for an opportunity to lock in 80% of the initial credit. This allows me to get out of the trade faster, which raises my probability of success in the trade. If I'm going to lock in 80% of the original credit, that means I'll keep $.44. Since my risk is still $1.45, that means my projected return on risk will be 30%. That's a pretty decent return really for this kind of trade.

Position sizing

The key to consistent gains and a stable trading portfolio is using a consistent risk amount. In order to make this an unemotional trade (as much as possible), small position sizes should be used. I use a percentage of my portfolio to calculate my risk amount. I'll risk 2% of my portfolio in any given trade. Some may be more conservative - and that's fine.

My portfolio value is currently $17,448, which means I can risk about $349. With a risk amount in this credit spread of $145 per contract, I can only sell 2 contracts and remain within the risk threshold I've given myself.

That means with a 2 contract trade, my target return (with the 80% exit rule) will be $88.

Exit plan

I said at the beginning of this tutorial that I was taking a bit of a chance on the trade. What that means is that there is still a risk that DIA (and the broader market) could go even higher. As a result, I want to put in a technical exit that triggers me to get out of the trade if new highs are created. The current high in DIA is $146.50. So, I might put a technical exit in place to close this credit spread if the DIA reaches $146.75.

I also will put an order in to close this credit spread when I can do so for $.11, which represents locking in 80% of the initial credit. So how do I have both orders in place? On the the thinkorswim platform, I can do so with a One Cancels Other (OCO) order.

Credit spread exits

One final exit I will employ is to close the trade absolutely with 4-5 days to expiration. This is to simply minimize gamma risk and ensure I can get out for a reasonable fill price. This order will be placed manually in the last week of the expiration cycle.

To summarize, I will exit under the following conditions.

  1. I will exit credit spread when I can do so for $.11 debit. This allows me to lock in 80% of the credit for a target gain in the trade of $88.
  2. I will exit if the DIA raises above $146.75. This gives a little of room to convince me that there is a real push above the previous high.
  3. I will exit when approximately 4-5 days of expiration

Portfolio Impact

This is the first time in a while that I've had more than one trade on at the same time. As a result, we need to look at how this bearish trade affects my previous bullish trade.

Credit spread portfolio impact

It's no surprise that we'd see somewhat of a balance with a slight bias one way or the other. At the moment, this bias is a bit bullish. I actually took this image capture after we saw some selling so it shows even more of a bullish bias. The nice thing is that I now have two positive theta trades in place so even more premium eroding away daily.

Update 4/9/2013 (closing update)

Ok, well this trade didn't last too long - 5 days to be exact. Remember, I had an OCO order in to close if DIA climbed above $146.75. This happened on Tuesday and then followed through yesterday with another strong move up.

This the price-based order triggered me out of this trade, so how did it turn out? The actual closing price for this credit spread was $.70. I received $.55 credit on the trade so my net loss is $.15 or $30 since I only sold 2 contracts. That's not too bad for a somewhat risky trade.

Why did this trade make sense when I entered it? At the time, I was thinking there was a top about to be formed. I still think that but you never know about the timing. As it turns out, having that technical stop in place saved this trade from being a larger loss. Any time there is a clear technical indicator that your assessment is wrong, it's not a bad idea to use it as part of the exit strategy.

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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