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Trade of the Week - Put Credit Spread (5/5/2010)

This trade is a put credit spread. I'm going to take a chance on this trade, betting that the selling is over. I actually put the trade on this morning when it looked like the bottom was forming. It's still a little early to know for sure, but it will be pretty clear if it isn't

IWM credit spread

Sell IWM 67/65 put spread
1. Exit if I can lock in 80% of my initial credit (i.e. $.09)
2. Exit if cost to close >= twice initial credit (i.e. $.86)
3. Exit if within 4-7 days of expiration
Credit $.43

I'll talk about my strategy for exiting early a little later. I mentioned in my latest newsletter that I would be looking for an opportunity to take a bullish position on a pullback. This looks like it might be it (emphasis on might).

Why this strategy?

The credit spread is my favorite bullish strategy. When the market is actually bullish, it can turn out to be quite profitable without requiring a specific action in a specific time period. I'm starting to look at bullish positions now because the IWM has shown some relative strength in recent months AND it has just pulled back to the 50 day MA.

It's really a combination factors that makes this a compelling trade.

  1. The market has sold off heavily for several days in a row
  2. The VIX has spiked to highs not seen since the January sell-off right before it resumed a nice run up
  3. The IWM is now at the 50 day moving average, which might act as a support level
  4. Most of the other major averages are at a support level as well (SPX at 1150, DOW 10750)

What does all this mean? Just that the odds are starting to favor a resumption of the up trend - or at least that a bounce may take place. It's also possible that the sell-off may continue, which is a contingency I need to take into account.

The other nice thing about the credit spread is it's tolerance for being wrong. Even if the IWM resumes selling off, I can get out of this trade with a pretty small loss.

Choosing the right strike prices

The choice of strike prices is a pretty straightforward process according to my trading rules. I will look to sell a short strike having a probability of expiring (in the money a penny or more) of about 30-35%. Also, I want to make sure there's at least 20 days. At this point, May only has 16 days left so this trade will be in the June option cycle. The strike that fits my requirements is the June $67 put.

credit spread strike selection

I will be buying a strike $2 farther out of the money creating a $2 wide credit spread with a $.43 credit.

Risk/Reward analysis

The reward on this kind of trade is pretty straightforward. The most I can make on the trade is $.43 if I let the trade go all the way to expiration. If I allowed the trade to expire completely in the money, the most I could lose is $1.67. In this scenario, the reward/risk ratio would be 25%.

On the other hand, consider the following scenario. I won't let the trade go all the way to expiration either way. I plan to close the trade early if I can lock in 80% of the credit. That means I'll give back $.09 and only keep $.34. Also, I'll close the trade if it cost me twice the credit to close. That means I'll potentially only lose $.43. In this scenario, my reward/risk ratio is 79%.

Position sizing

Since I've already stated my exit plan for the worst case scenario, I can now use this as the basis for my position sizing. As always, my position size is based on the maximum amount I'm willing to lose on any trade. I follow a rule of limiting my loss to 2% of my portfolio. Right now, my portfolio stands at about $18437, which means 2% would be $368. With a limited loss of $43 per contract, I can sell 8 contracts and remain within my risk tolerance.

Exit plan

I mentioned at the beginning of this trade page that I had a technical exit in mind when I entered this trade. Right now, the IWM is very close to the 50 day MA. If this support level holds, great. If not, then I'd say we're in for more selling. As a result, I intend to exit this trade early if it closes below the 50 day MA. Most likely this will happen before my maximum loss exit is triggered.

As usual, I will follow my 80% rule for the a credit spread (i.e. locking in 80% of my initial credit by paying 20% back). That means I'll close the trade if I can do so for $.09. In addition, I'll close if I have to pay $.86 to close the trade. That will represent my 2x rule to limit the loss. Of course I'll also be closing absolutely 4-5 days prior to expiration.

Just to summarize, I will exit under the following conditions.

  1. I will exit on a close below the 50 day MA. I will do this regardless of whether the other rules have triggered or not
  2. I will exit when it costs $.86 to close - I want to limit my loss on the trade to $344, which is less than my max risk amount of $368.
  3. I will exit when I can do so for $.08 - This allows me to lock in 80% of the initial credit
  4. I will exit when approximately 4-5 days of expiration

As always, I use the trading platform to help me enforce as many of these rules as possible. I do this because that way I don't have to be tied to the platform every day. Also, it helps me stick to my exit rules.

credit spread exit orders

As the above image shows, I can set up rules 2 & 3 to be triggered automatically with a one cancels other (OCO) order. I almost always have an order like this set up for credit spread trades because that way I don't have to remember to check the trade every day. I just set it and forget it. However, in the case of this trade, I will have to monitor the level of the IWM to make sure it stays above the 50 day MA.

Portfolio Impact

This credit spread is a bullish trade. As expected, it adds positive delta to the portfolio.

credit spread portfolio impact

Isn't it surprising that after a few days of selling our delta is now positive? Well this trade adds even more positive delta as well as theta. That's ok if my outlook is bullish. At this point, I'm cautiously bullish so this trade fits with my outlook just fine.

I'll need to monitor this position as time goes on to make sure my portfolio doesn't become too extreme - either positive or negative.

Update 5/6/2010 (Closing update)

Ok, this one caught me by surprise. I knew there was a possibility of a sell-off but not a state of complete panic.

In case you weren't watching, the markets went into a state of outright panic selling for about 10-15 minutes. The effect was that at one point, the IWM was down about $7 (equal to $70 on the RUT). The DOW was down 1000. Most of this was recovered, however it left the prices pretty badly hit.

Of course, the result was that I never got a chance to evaluate and invoke my technical exit rule but I had my stop loss rule in place, which got me out this credit spread trade at $.87 debit (the trigger was $.86). As always, I hate to lose money on a trade. However, I can live with a loss that is within 2% of my portfolio.

I won't spend a lot of time on analysis of this trade. It lost 100% of the credit which is $352 or just about 1.9% of my portfolio.

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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