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.
SPY 112/110 put spread
||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
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.
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.
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%.
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.
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.
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.
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.
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.
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.
Notice also that both trades continue to provide positive theta, which is the goal of the style of trading I prefer.
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...