Trade Tutorial - Put Credit Spread (4/28/2011)

I know I just put on a slightly bearish trade yesterday but this put credit spread is the reciprocal trade I mentioned I was considering.



Trade
Sell IWM June 83/81 put spread
ROI
32%
Exits
1. Exit if I can lock in 80% of my initial credit (i.e. $.10)
2. Exit if within 4-7 days of expiration
Credit $.49

As the chart above shows, the IWM and many other index ETFs are establishing new highs. As I mentioned in the calendar spread summary, there are two ways to look at the current circumstances. It either will lead to more buying or a pullback may take place at some point.

Why this strategy?

Since I'm entirely certain yet which direction the market I want to make sure I have a trade in place that could cover either contingency. This trade will benefit if the market continues it's current wave of buying. In fact, it's possible both trades could work out, however I'm not sure I'll leave the calendar spread in place if the buying continues.

The reason I went with another credit spread is that they are a fairly short term trade that could develop in as few as two weeks but could take up to 4 or 5 weeks if the trend stalls. I'm expecting the trade to develop in more of a shorter term.

Choosing the right strike prices

The credit spread strategy I employ calls for selling a short strike having between 20 and 50 days until expiration and a probability of expiring worthless of between 30 and 35%.

As you can see, the probability I selected is slightly higher that the range I mentioned. I did this because the market was on the move at the time and the next lower strike price puts the trade at the lower end of my threshold. As I write this trade page up, the probability of expiring dropped to 35.9%.

As I always do with these trades, I'm selecting a long strike $2 farther OTM to limit the risk in the trade. This makes the absolute risk in the trade $2. However with a credit of $.49,  the net risk is $1.51.

Risk/Reward analysis

With a potential reward of $.49 and a risk of $1.51, the reward/risk ratio is about 32%. That's a fairly reasonable return for this kind of trade. One point I want to make thought that could change the risk side of this equation. The strike price I selected is right at the 30 day moving average. As we move forward in and the IWM continues to move up, so will the moving average. If there is a pullback, I'm looking at the level around 84 to act as a support level. A failure to do so would be an early warning indicator to exit and preserve some capital.

Position sizing

My position sizing rules are designed to limit the risk in each trade to just 2% of the portfolio value. At the moment the portfolio stands at $16,606, which means I can risk $332 in this trade. With $1.51 (or $151) per contract at risk in this trade I can sell just 2 contracts. This will yield an absolute maximum return of $98 and an absolute risk of $302.

Exit plan

With the current trading plan, don't have many exit rules. However here they are. I will exit under the following conditions.

  1. I will exit when I can lock in 80% of the initial credit, which would be a debit of $.10
  2. I will exit when approximately 4-5 days of expiration
  3. I MAY consider an early exit if the IWM falls below $84. I will be placing an alert to warn me if this happens

Portfolio Impact

This trade is a bullish trade so the contributed delta is positive. The result of adding this positive delta to the portfolio is to bring it into a more neutral state.

Notice also that this trade adds additional positive theta. As it stands, the overall portfolio would increase in value if time simply moves forward and the market goes nowhere. That scenario is unlikely but the current mix of positions provides a fair amount of flexibility.

 

Update 6/15/2011 (closing update)

Woops! I forgot (again) to write the closing update. I closed this on 6/15, which was the Wednesday before options expiration.

I've mentioned lately the strategy to size my credit spread positions to sustain a maximum loss. Up until now, the strategy has worked well for me - even allowing the trade to stay in play when it was facing a loss at one point.

In this case, there was no hope for the trade. With a few days until expiration, there was virtually no chance it would work out. I closed the trade for a debit of $1.97. This saves me on two fronts. First, if I had let the trade go to expiration the total closing cost would have been $2 (per contract). Second, the commission for assignment and exercise is $15. The total cost would have been $30 since there is one fee for the assignment on the short strike and one fee for the exercise on the long strike.

On the other hand, it cost me exactly $6 in commission to close. Let's just look at the basic trade. I entered for a credit of $.49 and closed for a debit of $1.97. That's a net loss of $1.48 times two contracts is a total loss of $296.

I could have potentially taken action given the indications of breaking support. I said I might close on a break of $84, which happened not once but twice. In retrospect, the failure to stay above $84 might have been a good indicator of an exit. However, I want to be careful of complicating my basic strategy until we see whether it proves to be a better 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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