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Trade Tutorial - Put Credit Spread (05/22/2012)

So after some time out of the market, it's time for another credit spread. This one is a bullish trade following a fairly strong round of selling.

Credit spread trade setup

Sell SPY 139/137 put spread
1. Exit if I can lock in 80% of my initial credit (i.e. $.09)
2. Exit if SPY falls below $129.50
3. Exit if within 4-7 days of expiration
Credit $.44

Why this strategy?

As the chart above shows, it looks like we've seen a pretty heavy sell off that has taken the SPY almost down to the 38% retracement level. That's a pretty heavy amount of selling over the last two months. The bounce from yesterday and the potential continuation today indicate maybe the selling is over. Of course, this trade has some risk involved as well.

Given the potential of this being just a short term bounce, a short term strategy such as the credit spread probably makes sense.

Choosing the right strike prices

As always, I'm looking for a trade with a probability of success of around 65% or so. With the recent updates to the thinkorswim platform, this becomes fairly easy. It's simply a matter of selecting a put strike having a probability of expiring OTM of near 65%.

credit spread strike selection

In this case, that's the June $129 put, which has an actual probability of expiring OTM of 67.5%. I tend to prefer the $2 wide spreads so that means I'll simultaneously purchase a $127 put as protection to ensure the maximum this trade could ever lose is $2.

I can enter this trade for a credit of $.44, which means my actual risk in this trade is just $1.56.

Risk/Reward analysis

With a potential reward of $.44 and a potential risk of $1.56, my reward/risk is about 28%. So, as it stands, I have a reward/risk of 28% for a trade that has a probability of success of around 67.5%. Let's look at this another way.

As I usually do, I'll have an order to close the trade when I can lock in a profit of 80% of the initial credit. In this case, that means a target profit of about $.35. Since my overall risk hasn't changed, my new reward/risk is 22%. It wouldn't seem like a good deal to take a lowered reward/risk, however when I elect to close the trade early, my probability of success goes up.

While it's pretty hard to put an actual number to this probability, I've mentioned a number times the trade-off between return on risk and probability of success.

Position sizing

As always, I size my position to limit my risk in every trade to just 2% of the portfolio. The current portfolio value is roughly $17,300. That means I can risk $346 on this trade and remain within my risk tolerance.

The nice thing about a credit spread trade is that I know exactly what I will risk on the trade. In this case, the risk amount is $1.56, or $156 per each contract of the spread sold. That means I can sell 2 contracts and remain within my risk tolerance.

Exit plan

Ordinarily I only have a few exit rules for my credit spread trades. One is a rule to lock in 80% of my initial credit. The other is to close the trade 4-5 days before expiration regardless of the status of the trade.

In this case, I am adding an exit rule to get me out of this trade if my assumption is completely wrong. How do I know this? If the SPY were to drop below the previous low of $129.50, that would be a pretty good indicator that I was wrong in assuming the stock is bouncing.

How can both orders be in force? By setting up a One Cancels Other (OCO) order. I can set up both orders where when one order triggers, the other will be canceled.

To summarize, I will exit under the following conditions.

  1. I will exit when it costs $.09 to close, which allows me to lock in 80% of the initial credit
  2. I will exit if the SPY falls below $129.50, which prevents me from losing too much if the trade goes against me
  3. I will exit when approximately 4-5 days of expiration

Portfolio Impact

Since this is the only trade on at the moment, any greek values associated with the trade are also the portfolio greeks.

credit spread portolio impact

In this case, the trade is bullish so no surprise that the delta is positive. In addition, a credit spread has positive theta. That means that as time passes the premium value of the spread drains away causing the spread to profit as time passes.

Update 6/1/2012 (Closing Update)

Once again the market turned the other direction and the stop loss order closed out for a small loss.

I had hoped this trade would represent a good opportunity to get a bullish trade at a good entry. However, we apparently haven't seen the bottom yet. Fortunately, I had a contingency plan in place to close the trade if the SPY dropped below $129.50. The stop loss order triggered early on Friday as the market pretty much sold off all day. How did the trade do?

I entered the trade for a credit of $.44 and closed the trade for a debit of $.75. That makes a net loss of $.31 per contract. Since I sold 2 contracts, that's a total loss of $62.

While I hate losing money on a trade, what I hate more is losing a LOT of money on a trade gone wrong. The lesson here is that it is possible to take adequate precautions, especially when you can identify a clear measure of when your trade has gone wrong.

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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