Trade Tutorial - Call Credit Spread (7/13/2010)

Finally! Another trade. This is a call credit spread, which means it's a bearish position. This may seem crazy given the strong run but just look back a few weeks ago. Is this a risky trade? Stay tuned...

credit spread on the SPY

Sell Call 108/106 call spread
1. Exit if I can lock in 80% of my initial credit (i.e. $.12)
2. Exit if cost to close >= twice initial credit (i.e. $1.26)
3. Exit if within 4-7 days of expiration
Credit $.63

Why this strategy?

I mentioned in the last newsletter that I am still somewhat in a bearish bias unless I see some things change. Even with the above chart, we have an established downtrend that has lasted for a few months now.

I don't know for sure what will happen but as I write this trade summary up, the market closed up strongly. I'm willing to take this trade but keep it on a short leash. What would cause me to become neutral to bullish? If I saw a higher high established (meaning a close above about $105 on the DIA).

In the mean time, it may seem like trying to face down a car coming at you going 50mph. Certainly today's earnings have helped buoy the market but anything can still happen. I'm going to put on this bearish trade and add one additional exit that is a technical one.

Choosing the right strike prices

As with all my credit spread trades, I follow the same basic rules for strike selection. I want an option month that has at least 20 days until expiration and a short strike that has between a 30 and 35% probability of expiring ITM. This gives me approximately a 65-70% chance that the spread will expire worthless.

Credit spread strike selection

In this case, I'm going to select an August expiration cycle and choose the $106 call as a short strike. Notice that this one is right on the edge of my range. Even still, this trade is offering a nice credit. I'm leaning a little more toward the 30% probability just to give additional room for the DIA to move to the up side.

Almost all my credit spread trades I do with the index ETFs are $2 wide spreads. This offers a nice little spread size that allows me flexibility between number of contracts I sell and the credit vs risk. In this case, I'm ending up with a $108/106 call spread for a credit of $.63.

Risk/Reward analysis

There are two ways to consider the risk and reward of this trade. The one you go with depends on the way you trade this strategy, particularly the exit strategy. Let me quickly go over both.

This trade will bring a credit of $.63. With a spread of $2, my risk in the trade is $1.37. That makes my reward/risk ratio 45%. However, this way of evaluating the trade comes with a set of assumptions. It assumes that I'll leave the trade on and either experience the maximum gain ($.63) or the maximum loss ($1.37). That's one way to trade the credit spread strategy but it's not the way I trade it.

To evaluate the reward/risk for the strategy I employ, we have to look at my typical exit rules. My exit rules for this strategy are 1) exit when I can lock in 80% of the credit. For this trade, that means about $.50. 2) exit when it cost 2x the initial credit (which means I am risking an amount equal to the credit). In this trade, my risk would be $.63. That makes my reward/risk ratio about 79%. That's good enough for me to take the trade.

Position sizing

My position sizing plan is also directly related to the exit rules I employ. I've already talked about my exit rule if the trade goes against me. In this case, it means that my risk in the trade would be about $.63 per contract (x100).

Every trade I put on is designed to limit my loss to just 2% of the current portfolio value. The current portfolio value is $17,899, which means the amount I can risk on this trade is $357. Since my risk per contract is $63, that means I can only sell 5 contracts.

Does this seem a little smaller of a position size for this strategy compared to past trade tutorials? Notice the credit I received on this trade. The usual credit size I receive for a $2 wide credit spread is somewhere between $.45 and $.50 on average. This one is a little larger, which means my risk per contract is higher.

Exit plan

I've already mentioned two of my exit rules, which are the same rules I follow (or attempt to follow) on every trade. At the beginning of this tutorial I mentioned that I'm adding an additional technical exit rule. This rule is going to be a lot harder to automate, which means I'll need to be vigilant.

The technical exit I'm referring to is that I'll close this trade if I see a close above $105 on increased volume. By increased volume, I mean above average. The current average volume for the DIA is about 12.2 million shares. That may seem like a lot but even with the strong finish today, we didn't break that average. I'm not going to consider a break very seriously unless the volume is above average.

Just to summarize my rules for this trade then, here are my exit rules.

  1. I will exit when it costs $1.26 to close - I will limit my loss to $.63, which is equal to my initial credit.
  2. I will exit when I can do so for $.12 - I'm locking in slightly over 80% of the initial credit by doing so.
  3. I will close the trade no matter what if it closes above $105 on above average volume
  4. I will exit when approximately 4-5 days of expiration

Is there a way to ensure that these rules get enforced? Yes. I've mentioned the way I enforce rules 1 and 2 in many of my previous trade tutorials. I employ a one cancels other (or OCO) order, which is supported on the Thinkorswim platform. Here's what that order setup looks like.

Credit spread exit rules enforced

In the case of my technical exit rule, there are actually ways to set up an order on the Thinkorswim platform to do this. However this time, I'm going to use an alert. With an alert, I can set the platform up to notify me when a technical event takes place.

Credit spread technical exit with alerts

You can also get fairly complex with this but the the alert I have here is a simple alert to trigger when the mark price of DIA is at or above $105. This isn't exactly what my exit rule says but it will warn me and I can watch the trade closer.

Portfolio Impact

The last portion I want to cover is the impact of this trade on the overall portfolio. Prior to entering this call credit spread, I just had an iron condor trade on the SPY. This position has a slightly bearish bias to it because the market has run up some since I put the trade on.

Credit spread portfolio impact

This new trade adds more of a bearish bias as indicated by the negative delta. Does this pose a problem? Not if my outlook is somewhat bearish. Some people feel we should always strive to keep a neutral balance to the delta. I personally believe we want to ensure that our delta is consistent with our outlook. If we are bullish and our delta is negative, then I have a conflict I need to resolve.

In this case, I'm perfectly fine with a negative delta as long as my overall market bias remains bearish to neutral. The other attribute of this trade is that it adds positive theta. That means even with my bearish  portfolio, I could make money by time just passing. Those are the kind of trades I like!

Update 7/22/2010

The market has been all over the place since I first entered this trade. Initially, we saw a bit of a rally right up to the diagonal resistance line before there was any selling.

After a few days of selling, a higher low has formed putting this trade on yellow alert. With that higher low established, I decided to add a small put credit spread to this position making this an unbalanced iron condor.

There are two areas to pay attention to in regard to this trade that would cause the call spread to go to red alert (action should be taken). The first is a clean close over the diagonal resistance area that is right around $102 right now. The second would be a close above the recent high of around $104.

One of my exit rules was to exit the trade on a close above $105 with above average volume. This is still the case, however I'm beginning to do some adjustment even now. Today I sold a 3 contract $99/97 put spread for a $.42 credit. I will be setting up a close order for a limit of about $.08 and a stop of about $.82 per my usual credit spread exit rules.

The advantage of this added position is that it adds additional premium with no additional risk. In addition, it allows me to slightly shift my bias in the trade to a more neutral stance.

Update 8/2/2010

With the strong buying that took place, I was able to close the put spread for $.08 as planned. We are now back to just a call credit spread that is being seriously overrun.

With the pullback today, is it time to make another adjustment? Right now, I could close the call spread for about $1. I could buy a $109 Sept/Aug call calendar spread for about $.80. The calendar spread won't prevent a loss, but it can minimize the loss amount.

Another adjustment strategy is to simply buy back one or two contracts of the short call to create a back spread. The advantage to this approach is that if the DIA moves up strongly toward $110, the long $108 call will begin to offset the loss on the other spreads.

I'll be taking action today on one of these strategies (or perhaps several).

Update 8/9/2010

So I went ahead and made an adjustment to this credit spread. I initially sold 5 contracts of this spread. The other day, I bought back 2 contracts of the spread for $1.13 debit. I also bought back one contact of the short $106 call. What this leaves me with is a 2 contract credit spread and a 1 contract long call.

What's the benefit of this position? First of all, my risk has been reduced by the fact that I closed out 2 contracts. Second of all, with the long call, I begin to benefit as the DIA increase in price and pushed up through my upper strike.

This second strategy (buying back a short strike) is one I would employ only if my outlook was more bullish. And... given the fact that there are only 2 weeks left until expiration, this move needs to happen fairly quickly.

Update 8/15/2010

With the selling that took place over the last few days, I was able to close the remaining call spread for $.08. That leaves me with one contract of a long call left over from when I bought back one contract of my short $106.

In retrospect, it would have been a good idea to have left this credit spread trade alone. It would have been the perfect trade. However, that's hindsight. I over trade these positions largely because it gives me opportunity to discuss adjustment strategies.

The ideal finish for this option would be to have DIA recover back to the $108 level or higher. However, this is expiration week so we're running out of time. I'll post a final update once the trade is closed.


Update 8/23/2010 (closing update)

Well, the ideal case didn't materialize. That means my long $108 call expired worthless. Let's quickly review the statistics on this trade and then I'll wrap up with some lessons learned.

I originally sold 5 contracts of a $108/106 call credit spread for $.63. I later sold a 3 contract put spread for $.42. That's a net income of $441. I closed the put spread for $.08, 2 contracts of the call spread for $1.13, one short call for $1.71 and the remaining 2 contract call spread for $.08. That's a total debit of  $437. That leaves me with a net gain of $4.

I've talked several times about over trading and the risks associated with that. To get a better perspective on this, let's look at what this trade might have looked like if I'd have simply been content with selling the put spread. In that case, I'd have realized a net gain of $275 on the call spread and $102 on the put spread for a total gain of $377.

There are two important concepts to grasp when it comes to adjusting trades

  1. Any hedge or attempt to limit risk comes at a cost - usually in the form of giving up some of my potential profit. In this case, I made 3 adjustments and ended up doing a little better than break even (worse if you take into consideration commission)
  2. For some (myself included) there is a temptation to fiddle with a trade to adapt to every shift of the market. This can be dangerous to the trade as this trade illustrates. We have to be able to step back and look at the original rationale for the trade and the money management/exit plans that were in place when the trade was entered.

As I've mentioned before, I'm ok with making multiple adjustments on these trade tutorials because it give me an opportunity to illustrate different trade management techniques. The risk is that you may be tempted to throw the kitchen sink at your trades with results similar to this trade - or worse.

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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