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Trade Tutorial - Put Credit Spread (8/9/2010)

Today I entered another credit spread. This trade is on the EWZ, which has been a favorite of mine in the past.

credit spread trade on the EWZ

Sell EWZ 68/66 put spread
1. Exit if I can lock in 80% of my initial credit (i.e. approximately $.09)
2. Exit if cost to close >= twice initial credit (i.e. $.92)
3. Exit if within 4-7 days of expiration
Credit $.46

This trade looks like a pretty good setup. It's a $2 wide spread with a pretty decent ROI.

Why this strategy?

I'm starting to see more strength in the market and in particular, higher highs being established. It might be a little risky to jump into this trade ahead of the Fed announcement tomorrow but we'll see.

Any time I start becoming a little more bullish, a credit spread seems like a natural trade to consider. It's not as long term as a diagonal spread but also may not yield as good of a return. Also, the credit spread (or short vertical spread) is one of the more basic spread strategies with easy mechanics. I'll be covering this in a lot more detail in the up coming video I'll be releasing at the end of the month.

Choosing the right strike prices

My trading plan for a credit spread calls for selecting the short strike with a probability of expiring ITM of between 30 and 35%. I typically lean toward the 35% mark depending on how certain I am of my outlook.

credit spread strike selection

I also look for options that have at least 20 days until expiration. Right now, that's the September expiration cycle since August only has 11 days until expiration. My strategy also calls for typically trading $2 wide spreads. That means I'll be selling a $68/$66 spread for $.46 credit.

Risk/Reward analysis

Since I know I'll be receiving $.46 credit for this trade and I know that I have a $2 wide spread, I have everything I need to calculate the trade risk. It's simply $2 - $.46 = $1.54. That means my reward risk ratio is $.46/$1.54 or about 29%. That's true if I put this trade on and allow it to run it's course and potentially loose the entire $1.54. However, as those who have followed my prior credit spread trades know, I close the trade earlier than that.

My exit strategy calls for closing the trade if my loss amount reaches an amount equal to the credit I received. That means I'm actually risking $.46. I also close the trade early on the other side when I can lock in 80% of the initial credit as profit. 80% of $.46 is about $.37. With this strategy, my reward/risk ratio is $.37/.46 = 80%.

Don't be tempted to look just at the reward/risk or ROI. The thing to keep in mind is that there is no free money. If the ROI is better, it's because it comes with a lower probability of success. I've been trading this strategy for a while now using this particular exit rule. I believe starting at the beginning of the year, I'm going to change my exit strategy just to show some new trading techniques.

Position sizing

I've already mentioned that my risk in the trade should be limited to $.46 because I'll have an exit in place to close when the cost to close is 2x the initial credit. Currently, my portfolio stands at $18,200. I limit my risk in each trade to just 2% of the portfolio value, which would be about $364. Since I'm risking $.46 (or $46 per contract), I can sell 7 contracts and remain within my limit.

Exit plan

This may seem monotonous to those who follow these trades, but I want my exit rules to be exactly that. The only thing that should vary is the actual amounts, which are often based on my entry price. So, just to summarize my exits... I will exit under the following conditions.

  1. I will exit when it costs $92 to close - this will limit my loss to $.46
  2. I will exit when I can do so for $.09 - this locks in 80% of the initial credit
  3. I will exit when approximately 4-5 days of expiration

As always, I make sure that my first two rules are enforced with a OCO order (OCO stands for One Cancels Other). On the thinkorswim from TD AMERITRADE platform, the setup would look like this.

credit spread trade exits

Portfolio Impact

At the beginning of this tutorial, I said I was entering this trade because I was more bullish. I would expect then that the bias of the portfolio should be more bullish as a result of this trade.

credit spread portfolio impact

As it turns out, we've now moved to a positive delta, which isn't surprising. Notice also that I've added positive theta. That's a good thing because the back spread I created on the DIA is killing me with negative theta. Luckily, this should be closed in the next week or so.

Update 8/17/2010

This credit spread trade was starting to look like a loser but has recovered. After some selling and a bit of a recovery, EWZ is roughly where it was when I sold it two weeks ago.

I'm expecting EWZ to at least push sideways. Up until now, the time premium has not been eroding that quickly but that should accelerate now that we're into the last 4-5 weeks of the option cycle. For now, it's really just a waiting game.

There is a temptation during these dull sideways, up and down days, it's tempting to want to jump in and make adjustments just to be doing something. In fact, I've probably been guilty of doing this too much in these trade tutorials. However, I want to use these trades to illustrate trade management techniques that can be employed. The trick is to not be too eager in employing them because they often leave the trade less profitable.

Remember, you can use many of the adjustments I've illustrated to reduce risk in the trade but the price is usually a reduction in overall profitability of the trade. When considering a possible adjustment, make sure you're not your own worst enemy. Trading for the sake of doing something can act as a drain on your account.


Update 8/25/2010 (Closing update)

Wow! Talk about needing to stay nimble. This market has changed direction several times over the last month. This is very choppy by anyone's definition.

With the last few days of selling, the stop order on this credit spread triggered and so I'm out at a debit of $.92, which means the trade lost $.46 or $322.

This presents another opportunity to talk about trading psychology.  It's easy to get discouraged in a market such as this. Heck, I'm pretty discouraged with the indirection and the fact that I can't seem to get the direction right. The question is... from that state what does one do?

In order to stay in the business long term, a different approach is required. The questions to ask are... what can I learn? What can I do better? Sometimes, it's best to step back and look at a set of trades over a longer period of time. Are there any flaws in the technical analysis? Could different strategies have been chosen? Are there any flaws in execution?

It's tempting (and easy) to look for someone to blame... the market, institutional investors, myself, etc. This is not a productive exercise however. Better to take responsibility and ask: what can I do differently and better?

Watch for my attempt at this exercise in the next newsletter.

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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