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Trade Tutorial - Put Credit Spread (6/27/2013)

It's been a while since I've entered a tutorial. It's about time to enter a credit spread as a short term trade.

Sell DIA 157/155 put spread
1. Exit if I can lock in 80% of my initial credit (i.e. $.09)
2. Exit if within 4-7 days of expiration
Credit $.44

I know it's been a while since I've put up a tutorial. I usually take the time in these tutorials to walk through the strategy execution process I've outlined on the website. In this video, I want to focus a little more on showing an example of a trading plan as described in my recently released video.

Why this strategy?

Since the intent is to outline a trading plan focused on the credit spread (or short vertical spread). However, it would be good to discuss why enter now.

Looking at the current trend, it does appear to potentially be a down trend. Yet, notice the low point came very close to the 38.2% fibonacci retracement before closing up off the lows. From there, we've seen 3 buying days before a little pause Friday.

While not the best entry signal, a bounce at this point and the following rally are pretty compelling. Even better, this point now makes a good exit trigger as well.

Choosing the right strike prices

There are a lot of different ways we can approach the strike selection process. Any given choice has different pros & cons. I could select a strike farther out of the money as the short strike. That has a better chance of expiring worthless but the credit is low, which means the reward/risk ratio is pretty low. It also means that I have to make some choices about money management.

On the other hand, I could take a trade closer to the money. It means my credit is higher but it also means my probability of success is lower. So, which should I choose? Everyone's preference will be a little different. I've found personally my preference to be to take a slightly more aggressive position that allows me a reasonable reward/risk ratio.

I have historically looked for a position that has about a 65-70% probability of success. As the volatility has dropped, this has paid off a little less. However, with volatility a little higher these days, I can get a good overall price for a position such as this. In this case, that's the July $157 put.

This brings me to the next point, which is selection of the long strike for my credit spread. Once I've chosen the short strike, I simply need to determine how wide to make the spread. As someone has pointed out in the past, a $1 spread sometimes will pay better than a $2 in terms of the reward/risk ratio given the same starting short strike. This has to be evaluated against the cost of commission though. As we'll see in position sizing, the number of contracts sold can affect my overall profit if I sold 4 $1 wide spreads as opposed to 2 $2 wide spreads.

In my case, I'll sell a $2 wide spread for a net credit of $.44. That's a pretty decent credit considering there are now only 20 days until expiration.

Risk/Reward analysis

Now that I have both my strikes chosen and my credit, I can evaluate my reward/risk ratio - or return on risk. With a $2 wide spread, my maximum risk per contract is $200 ($2 x 100 shares per contract). However, my credit is $.44 so that means my maximum risk is actually $156. My reward risk (return on risk) is $44/156 = 28%.

That's not too bad of a return on risk. That comes with a probability of success of 67.5%. Remember that for a credit spread, the probability of success is the probability of the short strike expiring out of the money (OTM) by a penny or more.

What makes a good reward/risk ratio? Only you can decide that. Remember, the higher the return usually the lower the probability of success. So you are always going to have to balance those two things. I'm usually looking for a return on risk of between 25 and 30%.

Position sizing

Now we come to one of the most important parts of the trade. I need to decide how much I'll risk in this trade. It's important to focus not just on what I can make but also what I could lose. I already know my maximum risk in the trade is $156 per contract. How many contracts can I or should I sell?

The answer depends on your money management rules. I really only have two rules regarding money management.

  1. Only risk 2% of my portfolio per trade
  2. Consistently follow rule #1

Depending on your risk tolerance, you might only want to risk 1%. That's fine as long as you find a percentage that will work for you. My account balance is currently $17,404. That means I can risk $348 in this trade. Dividing my risk per contract into this amount means I can sell just 2 contracts to remain within my risk threshold.

That means my total potential gain will be $88 and my total potential loss will be $312.

Exit plan

As I plan my credit spread exits, there are a couple of considerations I need to make. Will I close the trade early for any reason if the trade goes against me? Will I close the trade early even if the trade goes in my favor?

One of the advantages of sizing my position for maximum loss is that I usually don't need to plan an exit if things go against me. However, it would be foolish to remain in a trade that has clearly gone awry. So, how will I know the trade has gone awry? Clearly if the SPY falls below the prior low of $155.73. So, I might pick a level such as $155.5 as an exit signal. Whatever loss I experience will likely be less than the maximum loss I would experience if I just let the trade expire fully in the money.

What about other exits? Should I consider adjusting the position rather than exiting? Should I close the trade early even if the trade goes in my favor? All of these decisions will come from my own trading preferences that have been tested out over a series of back testing scenarios as well as proven out over time.

In my case, I've found it beneficial to close the trade early when I can lock in a large percentage of the initial credit. How much? My preference is to look for 80% of the initial credit. That means that if I can buy back the credit spread for about $.09, I'll do so. That has the benefit of often getting my out of the trade earlier and raises my probability of success in the process.

From here on, I'm going to abandon my usual formula of going over exits and summarizing my exit rules. They are at the top anyway. I encourage you though to think through all the possible exits along with their advantages and disadvantages. Once you have some idea of the rules you want to follow, back test them and verify that they are reasonable before putting them into practice.

Remember, the rules as I've outlined in this tutorial aren't meant to be for everyone. They are more a way to illustrate the implementation of the rules already defined. Everyone must define their own rules and be confident in them.

I've gone through a number of mechanics and decisions that are part of the credit spread (or short vertical spread) strategy. If you'd like more detail, check out the Mastering Short Vertical Spreads video.

Update 7/9/2013 (Closing Update)

This trade closed with the gap up in the morning of 7/8. As a result, I actually got a slightly better fill price than originally expected. Let's take a look at the trade.

I sold this credit spread initially for $.44 credit. I had planned to close the trade for $.09 debit but got filled at $.07 debit. That means my net profit in the trade is $.37 times 2 contracts for a total of $74.

Looking back at the chart a few days after closing out the trade, one might be tempted to ask why I didn't just stay in the position longer. In this particular case, it would appear that I could have kept more of the initial credit if I had just stayed in a few more days. In fact right now, I could buy back the short strike for $.03 and that would have left me the possibility of picking up a few more cents if there is a strong sell off next week.

That fact is that as we are making decisions we don't know what will happen past the right edge of the chart. In this case, the market continued to rally and I could have done better. HOWEVER - the market could have just as easily sold off from here and my unrealized gains could easily have turned into a loss.

There are a myriad of strategies for dealing with either one of these scenarios. Some make the exit more complicated and others make for fairly simple exit rules. I'll leave it to you to figure out alternative rules. Feel free to share some ideas as readers might want to know other strategies for protecting profit.

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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