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Trade Tutorial - Put Credit Spread (6/15/2010)

Here's another credit spread trade to consider. Yup - it's bullish. I hope the chart below gives you an idea as to why.

credit spread on EWZ

Sell EWZ 63/61 put spread
1. Exit if I can lock in 80% of my initial credit (i.e. $.10)
2. Exit if cost to close >= twice initial credit (i.e. $.98)
3. Exit if within 4-7 days of expiration
Credit $.49

It's been a hard past month with many of my trades not doing well. However, I hope the lessons learned in the process have been profitable. The lesson I intend to illustrate on this trade is the power of using technical analysis to time the entry.

Why this strategy?

The above chart should tell the story as to why I'm choosing this strategy. A month ago, I was fairly bearish on EWZ as evidenced by the pairs trade I took several weeks back. However EWZ rallied off the lows in late May and formed a short term high (1). That in itself isn't bullish since it could have been a small bounce in a down trend. However, when EWZ did sell off, it formed a higher low (2) before resuming the move up. From that point, EWZ pushed above the prior high (1) to form a higher high (3).

That's a compelling bullish argument. At this point, a number of bullish strategies are open for consideration including a put credit spread, call debit spread, call diagonal spread, long call, short put and more. Anyone who has followed these trade tutorials for any length of time will know that the credit spread is my favorite strategy in a bullish to neutral market.

Let me just say that I don't feel there is enough evidence of a longer term bullish move to consider a call diagonal spread, although with more bullish evidence I would consider it for another position.

Choosing the right strike prices

With the credit spread strategy, I look for the short strike to have about a 30-35% probability of expiring ITM. On the Thinkorswim platform, that information is available as a column on the option chain of the trade page (as well as in many other places). I pretty much have this as a column I view all the time.

credit spread strike selection

Notice here that the short strike I have highlighted actually has a probability of expiring ITM of 36%. This happened as the market was drifting in early trading. A more conservative position might be to sell the short $62 rather than the short $63 put.

I typically sell $2 wide credit spreads when I'm trading the ETFs. Some time back I did an analysis various spread widths and found that generally the $2 wide spread represents the best balance between credit for risk and commission cost.

Risk/Reward analysis

The credit for this trade is $.49. That represents my maximum gain in this trade. With a $2 wide spread, that means my risk in the trade is $1.51. My ROI or reward/risk then is $.49/$1.51 or 32%. That's pretty decent for a credit spread.

Keep in mind that both my target profit and my projected loss will be less that those maximum numbers above. My typical exit rule for locking in profit is to attempt to lock in 80% of the initial credit, which in this case would be about $.39. I also limit my loss by using an exit rule to close when the cost to close is twice the initial credit. That means my risk theoretically is only $.49.

In that case, my reward risk is quite a bit higher at $.39/$.49 or 79%.

I mentioned recently in on of my trade tutorials that in this current climate, it may be that an early exit rule like my 2x rule could have a negative impact on my overall profitability of this strategy. There have been several cases where my exit rule has stopped me out only to have the market turn and ultimately the trade would have worked out.

I'm not throwing this out to cause doubt on the approach I use but to offer an alternative approach to trading credit spreads. I'm comfortable with my rules but the number of cases I outlined above might be difficult for some traders to recon with. There's nothing wrong with having a trading strategy that sizes the position for maximum loss, which would mean a smaller trade size but potentially higher profitability overall.

Position sizing

I'm going to size my position based on my 2x rule for closing the trade. That being the case, my risk amount per contract would be $.49.  At the moment, my current portfolio balance is $17,765. My trade risk per trade is 2% of this portfolio, which means my risk in this trade must be limited to $355.

My trade size for this position then will be 7 contracts (355/49). That will make my risk will be $343 and my margin amount will be $1400 of which $1057 will be covered by funds from my portfolio and $343 will come from the proceeds of the sale of the spread.

Exit plan

I've talked above about my exit rules for this trade in various places above so I'll simply summarize my exit rules below.

  1. I will exit when it costs $.98 to close - this will limit my loss to $343
  2. I will exit when I can do so for $.10 - this will lock in 80% of the initial credit for a total target profit of $273
  3. I will exit when approximately 4-5 days of expiration

With my first two exit rules, it's important to ensure that these will be executed in a timely manner - even if I'm not around. I find it's easier to simply place a set of orders to enforce these rules.

credit spread exit orders

On the Thinkorswim platform, it is possible to create a One-Cancels-Other (OCO) order that can do this as illustrated above. If you are trading option spreads such as the credit spread, it is important to have this kind of capability. Check with your broker to verify you can place these kinds of orders.

Portfolio Impact

Since this trade is a bullish trade, I would expect to see additional positive delta being added to to the overall portfolio.

In addition, this trade will add positive theta. Currently, I have a long call that is showing an extreme amount of negative theta given the current value. I may be looking at a way to convert this trade into a positive theta position in a separate trade.

Update 6/22/2010

I took the opportunity to sell a few contracts (3 to be exact) of a call spread after the strong move up of EWZ. It may be that the market is just pausing before heading higher or it could be that the may be some selling in the future.

In either case, the three contracts of the 72/70 call spread will add a bit more premium. The spread sold for $.58, which adds $174 to the trade, which will reduce the overall risk. I only sold 3 contracts because I'm not 100% convinced the bullish trend is over.

I've talked about making trade adjustments as 'nibbles' in one of my prior newsletters. This approach can help break the uncertainty deadlock in cases where you are unsure if you should take an action or not - or if you are torn between two choices.

Update 7/6/2010 (Closing Update)

This update is a little late considering the trade closed last week with the stop order triggering.

So here's what happened. Last Wednesday, the limit order I had to close the calls I sold a few weeks ago triggered and I closed the 3 contracts for $.10 debit. The next day, the market gapped down (and EWZ in particular). This triggered my stop order and I closed for $1.01 debit. That's a little over my initial stop order price but that's because the stop turned into a market order. This often happens when an order triggers on market open.

The net result then is that I put on 7 contracts of EWZ for $.49 for a total credit of $343. I sold 3 contracts of the call spread for $.58 for a net credit of $174. I closed the calls for $.10 debit for a net debit of $30 and I closed the calls for a debit of $1.01 or a net debit of $707. That makes my net loss in this trade just $220 or about $.31 per contract.

This could have been a lot worse if I hadn't sold the call spread. The question is whether there was anything I could have done or any lessons learned. Certainly there were indications of a pullback, but nothing that would have indicated a gap down of $3 on the market open. That's why I limit my position sizes when I place my orders. If it hadn't been for the fact that I sold a call spread, my loss on this trade would have been much worse.

This comes back to the question I've discussed before about sizing for max loss and letting the trade run. Now that we're a week past the initial event, it's clear that I could have stayed in the trade and it would have been ok. However on July 1, that wasn't so obvious. The trick here is to pick a strategy and stick with it. My strategy is to size for a loss equal to the credit. If you are tempted to try the other approach, I encourage you to back test it and then paper trade it to prove the strategy out. I talked about this in my latest newsletter. If you haven't done so yet, you can sign up and get access to all the back issues.

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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