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Trade Tutorial - Put Credit Spread (9/28/2009)

I'm a little late getting this credit spread trade up on the website. I originally put this trade on a week ago Friday. It's been a little hard to keep up to date with the travel but hopefully this tutorial will still be beneficial.

Sell SPY 109/107 put spread
1. Exit if I can lock in 80% of my initial credit (i.e. $.05)
2. Exit if cost to close >= twice initial credit (i.e. $1.15)
3. Exit if within 4-7 days of expiration
Credit $.50

Are we at the bottom of the recent round of selling? Truthfully, it is hard to tell until afterward. Nevertheless, you have to dip your toe into the water from time to time and last Friday's (8/19) bounce seemed a likely indicator.

Why this strategy?

It's often difficult to time an entry when the market has fallen the way it did recently. This has often been compared to trying to catch a falling knife. However, this trade wasn't entered blindly. Notice the chart above indicates the possibility that we have a higher low forming.

Note: In retrospect, this turned out to not be the final bottom, but sold back down to the lows around $111 before bouncing again. This time, it looks like we may have a decent bullish move. However, a more compelling indication would be a close over the past highs around $121.

As many who follow these tutorials are aware, I often select my strategies based what's appropriate given my outlook. Frankly, I'm not that outright bullish yet, but I think there is a decent chance of a short term run. As a result, I'm selecting a strategy that has a fairly short duration and a decent tolerance for being wrong. That's why I love the credit spread. In this case, I've selected a put credit spread on the SPY.

Why the SPY? The SPY is the ETF that represents the S&P 500, which represents a fairly diverse portfolio of stocks. In addition, the current price value of the SPY makes the corresponding options decently priced as well.

Choosing the right strike prices

As I do with all my credit spread trades, I look for a short strike in an option month with at least 20-30 days until expiration and having a probability of expiring (ITM) of about 35%. I usually will go slightly above or below this depending on the circumstances.

In the case above, I found a short strike on the SPY in September and having a probability of expiring of 36%. That means I have approximately a 64% chance that this option will expire worthless.

Given that I trade $2 wide spreads, my choice of a long strike to offset the risk of the naked short put is a long $107 put. That trade will yield a credit of $.50.

Risk/Reward analysis

The numbers for this trade are pretty easy to calculate. I have a $2 wide spread with a credit of $.50. My risk in the trade is $1.50. That makes my reward/risk .50/1.50 or 33%. That's not a super reward/risk, but it's not bad for this type of trade. The probability of success is still 64% since all I need is for the two options (especially the short strike) to expire worthless.

Position sizing

My position sizing plan is based on a strategy of only risking 2% of my portfolio per trade. Right now my portfolio is worth $17,082. That means I can risk 2% of that or $341. With a risk in this trade of $1.50/contract, that means I can sell 2 contracts and remain within my risk threshold.

Exit plan

With my most recent update to the credit spread trade strategy, I no longer have an early exit rule for trades gone bad (generally speaking). As a result, my overall exit rules are pretty simple.

  1. I will exit when I can do so for $.10 - This allows me to lock in 80% of the initial credit and allows me to exit a little earlier rather than holding out for the last few percent.
  2. I will exit when approximately 4-5 days of expiration. I always do this to ensure I get a better fill price and am not subject to gamma risk.

Portfolio Impact

I started with an empty portfolio (completely in cash). Since I'm slightly bullish at the moment, I would expect the result of this trade to add positive delta to my portfolio. This means I'll benefit from an upward move of the SPY, since I currently only have the SPY trade going.

Notice also that I have a little bit of theta in the portfolio. This number will increase as the trade get's closer to expiration as premium value tends to erode more quickly as the option approaches expiration.

Update 9/14/2011 (closing update)

I closed this trade as expected for a debit of $.10. This really was a textbook trade that was opened and closed in just a few weeks.

So let's recap the trade. I entered for a credit of exactly $.50 and closed for a debit of $.10, leaving a net profit of $.40. I sold 2 contracts, which means I realized a net profit on this trade of $.80. 

There's not much to say on  a trade that goes as expected. As I said when I set this trade up, I went with a credit spread because it does well in a short period of time (assuming the market goes as expected). Given that there were some pretty wide fluctuations in the market after I put the trade on, it's also a good thing there is a fair amount of fault tolerance provided!

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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