Trade Tutoriao - Put Credit Spread (9/24/2010)

As I mentioned I'm late putting this credit spread trade tutorial up on the site. I've been busy working on other projects and while I did get the trade entered, I didn't manage to get the page written up.

credit spread trade on the SPY

Trade
Sell SPY 112/110 put spread
ROI
25%
Exits
1. Exit if I can lock in 80% of my initial credit (i.e. $.09)
2. Exit if cost to close >= twice initial credit (i.e. $.88)
3. Exit if within 4-7 days of expiration
Credit $.44

This one is a little close to October expiration but I went ahead and entered it anyway. It was a reciprocal trade to my removing the call credit spread I had on.

Why this strategy?

As I was looking at the chart (at the time), it was becoming clearer to me that the market was to a more bullish slant. Of course a week later that seems obvious and perhaps 3 weeks ago might have been an early warning when the SPY jumped above the range it had been in for at week between $106 and $104.

At any rate, I had said my exit rule for the call credit spread would be a strong break over $113. I let the first break pass because the volume was fairly light. Friday morning showed indications that there might be a continuation.

So, in addition to removing my call spread for a loss, I went ahead and put the put spread on. The credit for this trade (if it closes profitably) will more than make up for the loss on the call spread I closed.

Choosing the right strike prices

With this credit spread strategy, there are two key rules I have for strike selection. There must be at least 20 days until expiration and the probability of expiring ITM for the short strike should be between 30 and 35%.

credit spread strike selection

The time until expiration for the October cycle is pretty close with 21 days. I went ahead and chose a strike with a 36% probability of expiring ITM to compensate a little. The choices were that or 30.5%, which would have yielded too low of a credit for the time remaining.

Note: You may or may not want to give yourself a little room in your trading rules to make these kind of choices. Clearly I could have shifted to November or simply not taken the trade. However it does offer the chance to illustrate that sometimes you may have to make decisions like this.

Risk/Reward analysis

The credit I received for this credit spread was $.44. That's a little lower than I prefer but that's largely due the the shortened time until expiration. With a credit of $.44 on a $2 wide spread, I will have a risk of $1.56. That's a reward risk ratio of 28%. That's not too bad but not too great either. This is assuming I let the trade go fully against me and I experience the maximum loss.

Let's consider another scenario. I typically have an early exit rule where I will close the position if it cost twice the initial credit to close. That means I experience a 1:1 reward /risk (theoretically). However, since I also close early to lock in 80% of the initial credit, I actually will only keep $.35 of the initial credit but will still be risking $.44 on the loss side. That means my reward/risk is actually 79%.

That's a whole lot better. However, as I've mentioned before... this sounds good but the price of getting that kind of reward/risk is that I may sometimes close a trade early only to have it work out. I've talked about this trade off several times in prior trade tutorials but wanted to emphasize it here again.

Position sizing

My overall trading rules limit my trade risk to just 2% of my current portfolio value, which currently is $16,906. That means I can risk just $338 on this trade. Since my risk per contract is $.44 x 100 (or $44), I can sell 7 contracts and remain within my risk limits.

The nice thing about this is that it allows me to offset even more of my loss, potentially making the combination of the two trades profitable.

Exit plan

Over the course of this trade tutorial page, I've discussed my main two exit strategies, which are closing to lock in 80% of the credit and closing to limit my loss. One other strategy I always employ is making sure I'm out of the trade within the last week before expiration. I do this for a number of reasons but mainly it's because of the significant increase in gamma in the options, which causes dramatic swings in option prices.

To summarize my exit rules for this trade, I will exit under the following conditions.

  1. I will exit when it costs $.88 to close - I want to limit my loss on the trade to $308, which is twice the initial credit.
  2. I will exit when I can do so for $.09 - I this will allow me to lock in 80% of the initial credit or $245 (this is also my target profit)
  3. I will exit when approximately 4-5 days of expiration

To make sure the first two rules get enforced automatically, I will use trade orders. On the thinkorswim from TD AMERITRADE platform, I can set up an OCO order as follows.

credit spread exit orders

Portfolio Impact

My initial goal in removing the call credit spread was to respond to the increasing bullishness. My initial portfolio delta was getting more negative, which is the direct opposite of my market stance. As a result, the combination of removing the call spread and adding this put spread adds positive delta to the position and helps neutralize the current negative delta associated with the remainder of the iron condor trade I have in place.

credit spread portfolio impact

Notice also that both trades continue to provide positive theta, which is the goal of the style of trading I prefer.

 

Update 10/8/2010 (Closing Update)

The trade went exactly as expected. After switching from a bearish credit spread to a bullish one, I now have a profit not only on this trade but on the two as a pair.

First, let's take a look at this trade by itself. I entered the trade for a credit of $.44 and sold 7 contracts. I closed the trade for a $.09 debit. That makes my net profit $.35 on 7 contracts or $245. That's a decent profit on that trade for sure.

If we were to consider both the original call credit spread, which lost $174 together with this one, then the overall gain was $71. That's not great but not bad considering some of the wild swings that have taken place recently.

I mentioned this as a lesson on the call spread tutorial as well but it's worth repeating. It is important to have clear signals to trigger exits. Furthermore, it's critical to take action on these because to delay might be costly - both in terms of potential loss in a trade as well as opportunity cost.

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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