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.
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
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.
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.
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.
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.
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
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.
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.
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.
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.
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.
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...