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Trade Tutorial - Call Credit Spread (9/14/2012)

It may seem strange to sell a bearish credit spread at this point but I had said in the last newsletter that I had intended to enter a bearish trade soon. I think the time has come.

credit spread trade setup

Sell SPY 152/150 call spread
compared with $151/150 call 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 $.44/.26

I'm going to do something a little bit different in this tutorial. Some time back someone asked me why I chose to sell a $2 wide spread as opposed to a $1 wide spread. I gave some answers in a recent newsletter. However, I wanted to actually allow set both types of trades up and follow them to see how they actually turn out.

Why this strategy?

The market in general has recently broken out to the up side. On the surface that would seem like a bullish indicator right? However, notice how far the SPY has moved away from the 30 day moving average. Think of the moving average like gravity. The farther you get away, the more gravity pulls it back.

So, is this the right time for a bearish credit spread? I'm going to take a chance that this is a good opportunity for a short term trade. By short term, I mean 3-4 weeks. It's highly likely that there will be a week or more of consolidation or even some selling back down to the moving average.

Choosing the right strike prices

As I mentioned, I'm going to actually enter two trades simultaneously using a $2 wide spread and a $1 spread so we can evaluate which one would offer a better overall return.

First of all, we'll start with the short strike, which will be the same for both trades. My rule is to find a short option that has at least 20 days until expiration and a probability of success of between 65 and 70%.

credit spread strike selection

In this case, I took a position a little farther out for a couple of reasons. First, call options tend to have a little more premium in them. Second, I believe $150 is a distinct area of resistance that should offer a safe position if the market decides to push a little higher.

As to the long strike, I'm going to enter this as two trades. For the $1 wide spread, I'm going to select the $151 long call for a net credit of $.26. For the $2 wide spread, I'm using the $152 long call for a net credit of $.44.

Reward/Risk analysis

The calculation for reward/risk analysis will be a little more interesting this time because we're analyzing both trades.

For the $1 wide credit spread, the credit is $.26 so the risk is $.74 making the reward/risk 35%. For the $2 wide spread, the credit is $.44 and the risk is $1.56 making the reward/risk 28%. So at this point it appears that the $1 wide spread has a better reward/risk. Is that the end of the story?

Remember on credit spread trades we close the trades early by locking in 80% of the initial credit. For the $1 wide spread, that would mean closing for $.05 and leaving a net profit of $.21. That make the adjusted reward/risk 28% (remember the risk amount doesn't change).

For the $2 wide spread, we're closing for $.09 leaving a net credit of $.35 making the adjusted reward/risk 22%. Again, it appears the $1 spread is doing a little better.

Before making the final assessment, we have one more thing to look at.

Position sizing

My overall position sizing rule is to limit my risk in any one trade to 2% of the portfolio. In this case I'm doing to separate trades so I'll use the same portfolio value for calculating the risk amount for both trades. The portfolio amount is currently at $17,489, which means I'll be risking $349 per trade.

For the $1 wide spread, the risk per contract is $74, which means I can sell 4 contracts and remain within my risk threshold. For the $2 wide spread, the risk per contract is $154, which means I can sell 2 contracts. That works out neatly for the sake of comparison.

Now, the final point I wanted to consider was the cost of commission. On the virtual trading account the commission per contract is $1.50. That means the 4 contract $1 wide spread would cost $12 in commission while the 2 contract $2 wide spread would cost $6 in commission.

Now, keep in mind that my credit spread trading rules include closing each trade early. So the total credit is twice what I listed above. So let's run the math really quick.

The $1 wide spread is entered for a credit of $.26 at 4 contracts for a total credit of $104. However, we are closing for a debit of $.05 so the net credit is $84. But... the total commission on this trade (in and out) is $24 so the final net profit would be $60.

The $2 wide spread is entered for a credit of $44 at 2 contracts for a total credit of $88. I'm closing the trade out for a debit of $.09 (per contract) for a net credit of $70. The total commission is $12 in and out for a final net profit of $58.

What does this prove? That it may or may not be a good idea to start considering $1 spreads for your credit spread strategy but ONLY if you have a commission of $1.50 per contract or more. It is important that before you consider switching your trading rules you closely perform an analysis such as I just did in this trade tutorial.

Exit plan

Management will be a little more complex because of the two trades but in general, the rules don't change. As I discussed earlier, I will be closing the trade to lock in a profit of 80% of the initial credit. Regardless of which spread width I use, all my credit spread trades are closed the last week of the option cycle.

So, let's summarize. I will exit under the following conditions.

  1. I will exit the $1 spread when it costs $.05 to close locking in a net credit of $84 (not counting commission). I will exit the $2 spread when it costs $.09 to close, locking a net credit of $70 (not counting commission).
  2. I will exit when approximately 4-5 days of expiration

Portfolio Impact

This is kind of an odd tutorial in many respects. In terms of portfolio impact, I'm looking at two different credit spread trades but notice the quantity of contracts. I've sold 6 contracts of the $150 call and bought 4 contracts of the $151 and 2 contracts of the $152. What is the overall impact?

credit spread portfolio impact

It's no surprise that I have a negative net delta. This is a bearish trade in a portfolio with no other trades. That is consistent with my expectation that the market will likely sell off some.

My net theta is positive as it would be for any credit spread. With a total of 6 contracts sold, the initial theta is somewhat small but will grow over the next few weeks.

Update 9/26/2012 (Closing Update)

This turned out to be a fairly short trade. After hovering around at the highs for a week or so, the market suddenly sold off just enough to allow both trades to close at the target price.

Let's quickly go over the numbers on these two credit spread trades and then do a final analysis on how each performed.

I sold the $1 spread for $.26 credit and closed it for $.05 debit for a net credit of $.21. I sold a total of 4 contracts on this trade for a net profit of $84 (before commissions). In the virtual trading account, I pay $1.50 per contract. Since there were a total of 16 contracts traded (8 when I sold, 8 when I bought back), the total commission cost was $24 for a final net profit of $60.

On the $2 wide spread, I sold for $.44 credit and bought back for a $.09 debit for a net credit of $.35. I sold 2 contracts, which makes my net profit $70 (before commissions). In this trade there were only 8 option contracts traded, which makes the commission cost $12 and my net profit on this trade $58.

What would have happened if the commission per contract was $2? In that case, the total commission for the $1 wide spread would be $32 for a final net profit of $52. On the $2 wide spread the commission would have been $16 for a final net profit of $54 making the $2 wide spread slightly more profitable.

Let's quickly look at a less expensive commission. For a $1 per contract commission, the $1 spread would have cost $16 making the net profit $68. For the $2 spread, the commission would have been $8 making the net profit $62. In this case, the $1 wide spread was a better choice.

We began this tutorial with an objective of evaluating whether a $2 spread or a $1 spread would be better. In this case, the difference was very minimal. What we're going to discover is that what determines which is better is the commission rate. It's important that you understand how commissions will be handled by your broker for different kinds of trades.

Some brokers will charge a flat 'per strategy' type fee plus a per contract commission. All of these factors will affect the final net profit. For the purposes of instruction, I've left commission off the analysis but as you can see above, the commission rate does matter.

Take the time to run the analysis as I've shown above to determine for yourself what makes sense.

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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