Trade Tutorial - Call Credit Spread (9/14/2010)

I'm entering another trade - this time a call credit spread. 

Credit spread trade on the SPY

Sell SPY 117/115 call spread
1. Exit if a decisive break above $113 occurs (more detail below)
2. Exit if I can lock in 80% of my initial credit (i.e. $.11)
3. Exit if cost to close >= twice initial credit (i.e. $1.08)
4. Exit if within 4-7 days of expiration
Credit $.54

This is a bit of a counter trend trade in the sense that it goes a bit against the near term trend, which is bullish.

Why this strategy?

I'm taking this trade because the market in general and SPY specifically have been trading in a range. While it's a fairly wide range, it still poses a potential risk (or opportunity). There is a reasonable chance that the overhead resistance around $113 may hold, at least for the short term.

It's on this chance that I'm entering this trade. Obviously if the SPY breaks decisively above $113, the trade rationale may be wrong. For this reason, I believe it makes sense to add a technical exit rule.

In summary, this is a bearish trade being put on in the face of reasonable market bullishness. However, it is done with the assumption that the resistance at $113 will hold initially.

Choosing the right strike prices

Since this is a standard credit spread, the standard rules apply for strike selection.

credit spread strike selection

I will choose a short strike that has a 30-35% probability of expiring ITM. Notice in this case, the probability is slightly lower than this but that's because I already had the trade set up when the market began to sell off a little. I went ahead with the trade anyway because the credit was still decent.

As always, I select a long strike $2 away making the absolute risk in the trade $2 less the credit.

Risk/Reward analysis

In this type of trade, the ratio of credit to risk is usually 3:1. In this case, the credit is $.54 making the actual risk $1.46. If left alone, the reward/risk would be about 36%. However, I typically employ a slightly different exit.

In the case of my credit spread trading strategy, I usually exit when the cost to close is twice the initial credit. In this case, my risk in the trade is actually only $.54. Another exit rule I have is to close when I can lock in 80% of the initial credit. In this case, I close when I can do so for $.11 leaving a net profit of $.43. In this case the reward/risk is actually 79%.

Position sizing

Since I've already discussed the risk in this trade, all that left to do is divide it into the risk I intend to take in the trade overall. I typically risk 2% of the current portfolio value. This currently stands at $17,080. That means I can risk $341 on the trade. That means I can sell 6 contracts and remain within my current risk tolerance.

Exit plan

I've pretty much discussed all my intended exits above. I have one technical exit and an best case and worst case exit. In addition, I have one exit rule that is always in place, which is to close the trade within the last 4 days or so before expiration. I've explained my rationale for this in several places including the January 2010 newsletter.

In summary, my exit rules are as follows.

  1. I will exit on a technical breakout over $113 where the move decisively clears $113 on increased volume.
  2. I will exit when it costs $1.08 to close - I want to limit my loss on the trade to $.54 per contract, which is equal to the initial credit I received
  3. I will exit when I can do so for $.1 - This will allow me to lock in 80% of the initial credit or $.43.
  4. I will exit when approximately 4-5 days of expiration

Portfolio Impact

Prior to entering this position, my portfolio was already bearishly biased. I had initially entered a fairly neutral iron condor but closed the put spread leaving just a call credit spread. Now I'm adding an additional call credit spread.

credit spread portfolio impact

This doesn't bother me because at the moment I'm a little more bearish in the short term (2 weeks or so). As you can see, the portfolio now has a more negative delta than before but still is collecting positive delta. This is the goal of most of my trades.


Update 9/28/2010 (Closing Update)

I ended up closing this position last Friday (sorry for the delayed update). If you remember, Friday started out strong and got stronger. I closed the position in the morning as it looked like it was going to be a strong buying day - and it was.

Here's the trouble I had with this whole recent round of buying. If you look at the volume during this time, it was pretty average and even a little below average. I'm frankly still suspicious but my rule said close on a definitive break over $113. I think a second time in a week qualifies. I actually switched horses and entered a put spread position. I'll try to get that trade page up this week as well.

Here's the closing summary. I entered the position for $.54 credit with 6 contracts. I closed the position last Friday for $.83 debit leaving a net loss of $.29 times 6 contracts or $174. This is obviously much less than the amount I sized the position for. Any time you can get out on a bad trade and lose less then intended, that's a good thing.

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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