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Trade Tutorial - Put Credit Spread (7/30/2012)

Given the recent break over resistance, a credit spread seems in order. Check out the chart below.

Credit spread trade setup

Sell SPY 134/132 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 $.46

Why this strategy?

If you look at the chart above, there are several indicators that make a bullish trade a compelling option (no pun intended). First, we are in the process of establishing another higher high & higher low. With the breakout, the next level of resistance near $141.

That said, the risk is that there is a prolonged medium term up trend that may suggest a pause. Therefore, I'm going for a relatively short term trade. The logical bullish trade with a short term result is a credit spread.

Choosing the right strike prices

When I trade a credit spread strategy, I'm looking for a short strike that has at least 20 days until expiration and a probability of success of around 65%.

Credit spread stirke selection

That set of requirements leads me to select a short strike of a Sept $134 put. I considered, briefly, an August option but it was a little short of the 20 days I like to have. When there are fewer days until expiration, there isn't enough premium value to make the trade worthwhile.

As usual, I like to sell a credit spread that is $2 wide. That means I'll purchase a long strike $2 below the short strike. The net credit for the trade is $.46.

Risk/Reward analysis

With a $2 wide credit spread and a $.46 credit, my risk in the trade is $1.54. That makes my reward/risk ratio of 29% However, that assumes I let the trade go until expiration. As followers of these trade tutorials are aware, I never let these trades go until expiration. I'll close the trade when I can lock in 80% of the initial credit.

That means I'll close the trade when the cost to close is $.09, leaving a projected return of $.37. Since the overall risk in the trade doesn't change, that means my real return on risk is 24%. Of course this is lower than my original calculation but the key is that the probability of success is higher since I'm not holding the trade until expiration.

Position sizing

Since my risk in this trade is $1.54 per contract, I can easily calculate my position size. My current portfolio value is $17, 415. My standard position sizing rule is to limit my risk in each trade to just 2% of that portfolio, which is $348. That means I can sell just 2 contracts and remain within my risk tolerance. That will leave my total risk in the trade at $308 ($1.54 x 2 x 100).

Exit plan

As I mentioned, my standard exit rule with credit spreads is to close when I can lock in 80% of the initial credit. My other exit rule is to make sure that I absolutely close the trade if I'm within 4 days of expiration. I sometimes have an additional exit rule that will stop me out of the trade. In this case, I'm not using any early exit of this kind.

To summarize, I will exit under the following conditions.

  1. I will exit when I can do so for $.09 - That allows me to lock in 80% of the initial  credit, which means a target profit in the trade of $74.
  2. I will exit when approximately 4-5 days of expiration

Portfolio Impact

Since this is the only trade entered and it was a bullish trade, it isn't a surprise that the overall portfolio delta is positive.

Credit spread portfolio impact

I prefer trade strategies that have a positive theta, which means the trade makes money simply by time passing. Both of these characteristics make for a trade that should profit in the coming weeks, especially if the market continues to rally.

Update 9/6/2012 (Closing Update)

After being open for just over a month, this trade has finally closed profitably. This has probably been one of the longer credit spread trades I've had open.

Let's take a moment to review the trade. I sold 2 contracts at $.46 credit and closed for $.09 debit for a net profit of $.37 per contract. That means my net profit in the trade is $74. Remember, my total risk in the trade was $308 so my return on risk is 24%. That's not too bad for a 5 week trade.

Usually credit spread trades will reach a point of exiting profitably at around 3 weeks or so. Why did this one take a few extra weeks? First of all, when I chose the September option cycle, the August cycle had 18 days (too short really) and the September cycle had 53 days. By choosing the September cycle, I automatically built in a longer trade cycle because premium really starts dropping off only in the last few weeks.

The second reason this trade took longer was that the market didn't just go straight up. It had many ups and downs and the past several weeks were kind of a consolidation period. The result was that this trade required a little more patience to let it develop. But... waiting paid off!

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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