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Trade Tutorial - Put Credit Spread (5/31/2011)

I'm feeling that it's time for another credit spread. This trade will be a bullish put spread that could take advantage of the apparent change in trend.

Sell SPY 131/129 put spread
1. Exit if I can lock in 80% of my initial credit (i.e. $.10)
2. Exit if the SPY drops below $131.30

3. Exit if within 4-7 days of expiration
Credit $.49

Why this strategy?

We've seen a short term downtrend develop over the course of the last month. However, the action today is giving the indication that perhaps we may be seeing a reversal of the trend. Of course, the change in trend has not proven itself yet so we have to approach this trade with a bit of caution.

I'm selecting a put credit spread because if offers some degree of tolerance for being wrong and has the potential to develop in a relatively short period of time. As I said, since this change in trend hasn't proven out just yet, we'll need to watch it and plan an early exit even though it's been position sized to take the maximum loss.

Choosing the right strike prices

I started out looking at June options, but there are only 17 days remaining in the June cycle. While I considered the June quarterlies, which have 30 days remaining, I ultimately went with the July options. With the lower volatility, more time is required to get any kind of decent premium.

Once I settled on the the correct month, I looked for a short strike having a probability of expiring around 35%. In this case the strike I selected had a slightly higher probability of expiring ITM. With a $2 spread, I'm looking at a credit of about $.49.

Risk/Reward analysis

With a credit of $.49 on a $2 spread, I'm looking at a risk amount of $1.51. That means my return on risk is 32%. That's not too bad of a return given the probability of success is around 68%.

I've mentioned recently that I've changed my exit strategy and my position sizing strategy. I now size my position such that I can sustain maximum loss. As a result, I have no early exit strategy as a rule that might improve my return on risk. As I've mentioned before, return on risk and probability of success are always a trade off. I've decided that removing the constraint that causes me to exit the trade early in some cases may in fact give me more opportunity to be right. So far, that has proven to be a good decision.

Position sizing

Given that the trade has a risk of $1.51 or $151 per contract, I now have a starting point to begin calculating the number of contracts I can sell.

My current portfolio value is $17,638. I have a trading rule to limit my trade risk to 2% of my portfolio so that means I can risk $352. That means I can sell 2 contracts and remain within my risk threshold.

Exit plan

Now that I no longer have a 2x rule on my credit spread trades where I exit when the cost to close is twice the initial credit, my typical exit rules are pretty simple. I will close when I can lock in 80% of the initial credit and I will close regardless when I'm within 4-5 days of expiration.

I mentioned early on that I intended to put this trade on a 'short leash'. What I mean is that if the trend fails to prove out I will close the trade. The point at which I feel the trend fails will be around $131.38. This would signify a lower low has been established. For now, I'm going to set an alarm to warn me if this happens.

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

  1. I will exit when I can do so for $.10, which allows me to lock in 80% of the credit.
  2. I will exit if the SPY breaks the recent low of $131.38. This will prove the trend has not reversed and it's best to get out and preserve some capital.
  3. I will exit when approximately 4-5 days of expiration

Portfolio Impact

Given that I'm presuming a short to medium term bullish trend, I am expecting that any trade I put on will have positive delta. It's no surprise then that this trade adds positive delta.

Of course I'd also expect this credit spread trade to add positive theta. This trade does add positive theta but notice that the IWM trade currently has 3 times the theta that this new trade has. Both trades have the same number of contracts. So why is the theta different?

The answer is that theta erodes faster in options closer to expiration than those farther out. I'd expect the theta to increase on this new option as more time passes.


Update 7/7/2011 (closing update)

Sorry folks, I let this trade run without any updates. This trade finally closed today (for a profit). I'll talk about the trade itself as well as discuss how I managed this trade in the face of my exit rules.

First, let's look at how the trade turned out. I entered the trade (2 contracts worth) for a credit of $.49. I closed the trade today for a debit of $.10 leaving a net profit of $.39. With two contracts, my net profit in the trade is $78. My return on risk is $.39/$1.51 or 25%. That's not too bad on a strategy such as this.

I want to address the exit rules I listed above and my choice to not follow them explicitly. I mentioned that one of my exit rules for this trade was to close if the SPY breaks below $131. This event did indeed happen shortly after entering the trade. As I considered exiting based on this rule, I started thinking about my motivation for altering my overall trading rules for the credit spread trades. The goal was to size my position so that a maximum loss would keep me within my acceptable 2% portfolio loss. The reason I did this was based on the theory that staying in trades longer gives me a better chance of success.

As of this trade, I've traded 6 times using this new exit strategy. Of those trades, only one was a losing trade. As it stands, my gains in the successful credit spread trades this year almost exactly equal the loss amount of my one losing trade. Had I closed the trade as planned, then I would have been slightly negative on this strategy. I point this out because while it doesn't seem exciting to have 5 gains wiped out by one loss, I did a lot worse last year using my 2X exit strategy. Of the trades I've done this year, I would have exited two of them early had I followed my 2X rule.

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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