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Trade of the Week - Put Credit Spread (5/7/2010)

First of all, I apologize for getting this credit spread trade page together so late. I actually put this trade on Friday morning and got tied up with other things.

Credit spread entry on IWM

Sell IWM 64/62 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. $.94)
3. Exit if within 4-7 days of expiration
Credit $.47

I had a similar credit spread closed early with a loss just a few days ago. With the heavy selling and subsequent recovery, this looks to be a better position.

Why this strategy?

There's no denying that IWM has had a heavy round of selling, which of itself is pretty bearish. On the other hand, after such heavy selling - reaching almost to the 200 day MA and then bouncing,  this seems to me to be the beginnings of a bullish argument, however there is still risk.

I may look at some bearish trades (like call credit spreads) after more of a rally takes place because I believe the longer term trend is still bearish for the time being. In the mean time, I believe this credit spread has a good chance of success as long as IWM stays above $64. As I write this, IWM is near $69.

Choosing the right strike prices

This trading plan calls for selling a short strike with a probability of expiring ITM of 30-35%. That means that the probability of the trade expiring worthless is 65-70%. This provides a nice balance between risk and payout. I could take a less risky trade but I would get paid less and potentially incur more risk if the trade turns against me.

credit spread strike selection

In this case, the short June $64 put had a probability of expiring right at 35%. As usual, I will sell a $2 wide spread so that means I'll buy a $62 put to cover my risk. This yields a spread that will pay $.47 credit.

Risk/Reward analysis

I have to consider that any trade I put on has a risk of failure. With credit spreads, it's tempting to focus on the $.47 I could make rather than the $1.53 I could lose. I did this analysis on the last credit spread trade and I think it's worth doing again.

This trade yields a $.47 credit, which is the absolute most I could make if everything goes right. If the trade goes completely against me, I'd have to pay $2 to exit but since I received $.47 in credit up front, I only would lose $1.53. This represents my maximum risk in the trade. Given this, my reward/risk ratio is 30%. Of itself, that's a pretty decent ratio.

Another way of looking at this trade is from the perspective of my trading rules. For a credit spread, I will exit when I can lock in 80% of the initial credit, which would be about $.37. That would be my potential gain in this scenario. I would also close the trade if it cost me an amount twice the initial credit. In this case, that would be $.94. Because I received $.47 in credit initially, my loss amount would only be $.47. In this scenario, my reward/risk ratio is 80%.

Given that the second analysis appears to yield a better reward/risk, it is natural to assume this is the better trade. Remember that risk and reward are always a trade-off. In the above case, I'm improving my reward/risk ratio but trading off success rate. It means that I will exit a trade earlier and with that carry the risk the trade may have worked out anyway. Take the previous trade as an example. My 2x rule caused me to exit with the major sell-off but today, the trade would OK.

If using the maximum loss scenario in the first scenario allows me to stay in the trade longer, why not use that approach? Some do and have success. The thing is that that scenario requires a smaller position size because the risk is higher.

I'm taking the time to point all of this out because it's important to realize that there are many variables in trading, most of which affect risk and reward. I've been in the habit of using my 80%/200% rule, which works pretty well in lower volatility markets but may not be as effective in more volatile markets.

Position sizing

In this credit spread trade, I used the 80%/200% rule to size my position. That means the risk I'll be taking per contract is $47. The one thing that remains constant in every trade is that I limit my risk to just 2% of my portfolio. With the recent trades going against me, the portfolio is now at $18,473, which means I can risk just $369. That means I will only sell 7 contracts to remain within my trade risk limitations.

Exit plan

Given the risk/reward approach I covered above, I will follow a fairly strict set of exit rules. I will exit under the following conditions.

  1. I will exit when I can lock in 80% of my initial credit - when the cost to close is $.09 or less.
  2. I will exit when the cost to close reaches twice my initial credit - or $.94
  3. I will exit when approximately 4-5 days of expiration

As always, I use limit orders and stop losses to manage my exit rules. On the Thinkorswim platform, I can set up a one-cancels-other (OCO) order to enforce rules 1 &2.

credit spread trade exit

Portfolio Impact

Just over a week ago, I had a portfolio that had a fairly negative delta, indicating a bearish bias. Now after just a week of selling, my portfolio delta is more positive, which indicates a bullish bias.

It isn't so much a concern if the delta number is a larger number like 147. The more important point is whether the number is consistent with your overall bias. I'm OK with a delta this large since I'm more bullish in the near term.

Notice that my theta is slightly negative. Why is this? It comes from the remaining put credit spread on EWZ that is currently completely run over. This can sometimes skew the overall portfolio numbers. Not counting the EWZ position, my theta would be about 5.7 or so.

Update 5/28/2010

With the strong buying from yesterday, IWM is now back above the short strike of this credit spread. For a while there, it was a pretty close thing.

At this point, IWM closed Friday at around $66, which is $2 above the short strike. Assuming this bounce continues, the spread should continue to gain value and we should be able to exit as planned. Given the volatility in the market it may even be worth looking at lowering the profit target on this credit spread.

I think that's a viable strategy in volatile markets, but I currently don't have a trading rule in place to that effect. We may want to consider something like that - or perhaps adding to the position with a credit spread to lower the overall risk and add more premium.

Update 6/7/2010 (closing update)

I missed the getting this update out last week when the trade closed. This trade was an example of how to mis-manage a trade. So, I'm going to turn my mistake into a lesson on the importance of trade management and always staying vigilent on opporunities.

I said at the beginning of the trade that I would look for an opportunity to maybe sell some calls to turn this credit spread into an iron condor. Let's look at this in more detail.

credit spread post trade analysis

Here's the key thing. I missed the opportunity to sell even a partial call credit spread during the highs in the middle of May. I probably wouldn't have caught the high point exactly, but what about when the lower high was formed several days later. There is about 5 days or so when I could have gotten a call spread in place.

One advantage to that is that it would have probably changed my exit plan. The additional credit would have given me more tolerance for the trade going against me. This may have allowed me to stay in the put spread instead of getting stopped out. Notice that right at the bottom of the selling when I got stopped out, the market turned and hasn't looked back (yet).

One other point I want to discuss is the exit rule I currently have in place for credit spreads. I automatically exit when the cost to close is twice the initial credit. I have this rule because it allows me to sell more contracts, which means I make more when I'm right. However, there are many times when this rule stops me out only to see the market reverse and the trade would have worked out. This is an example of that.

The question is; should I change my rule? Perhaps. I raise this point not to question my own rule but to point out that my exit rule isn't the only exit rule one could use. An alternative rule would be to not exit except to lock in profit or when within the 4-5 day expiration window. This will have an impact on position sizing though. In this case, my credit was $.47 making my total risk $1.53. Instead of selling 7 contracts, I would have only been able to sell 2. However, this trade would have made $75 instead of losing $329.

As a trader creating your own trading rules, the decision you have to make is what approach suits you and your trading preferences. Is your tolerance for loss low? Are you ok with smaller gains but having more winning trades?

Your trading rules should be an expression of your trading preferences and style. They should also be such that you are able to sleep at night.

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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