Trade Tutorial - Put Credit Spread (10/5/2010)

I'm entering another put credit spread as I mentioned in my last newsletter. I think we've seen enough confirmation that the trend is continuing.

IWM put credit spread trade

Sell IWM 65/63 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 $.48

I entered this trade back on Tuesday and it already is looking like a pretty decent trade.

Why this strategy?

In my last newsletter, I said I was becoming more bullish on the overall market but was looking for a push above the recent consolidation area. I may have jumped the gun a little bit but the market was showing strength. Early morning volume as well as advancers vs. decliners was suggesting this would be a strong up day and it was.

I also mentioned several bullish strategies I was looking at. I consider the credit spread a little more fault tolerant than the diagonal spread so I'll enter the credit spread now and look for a nice pullback to enter the diagonal spread.

Choosing the right strike prices

With just a few weeks until October expiration, I'm looking at November options to sell this spread. My trading plan for credit spreads suggests I sell a short strike with a probability of expiring ITM between 30 and 35%. That should give me a probability of expiring worthless of 65-70%, which is the goal of this strategy.

credit spread strike selection

I chose a short strike that was a little more aggressive than my strategy calls for. This is mainly due to my bullishness. When I considered the next strike down, I found it wasn't paying as much for the risk I was taking on.

In the 'Answers to Your Questions' section of the last newsletter, I talked about the combination of technical analysis and probability of expiring. Given the recent consolidation area above $65, I felt this was a safe selection. This is a further example of the power of combining the two approaches for strike selection.

Risk/Reward analysis

The credit on this trade is $.48 on a $2 wide spread. That means I have $1.52 in risk in the trade as it stands. The reward/risk ratio is 31%. That's not a bad reward/risk but it could be better. The maximum risk in the above calculation assumes that no adjustments will be made but that it will expire completely ITM or completely worthless.

Another way to calculate reward/risk is to consider it with respect to the exit rules I typically follow for a credit spread. I usually employ two different rules for closing the trade. The first is designed to lock in 80% of the credit, which means the reward would be 80% of $.48 or about $.38. My other exit rule is to close the trade when the cost to close is twice the initial credit. That means I'll risk just $.48 to make about $.38. The reward/risk for this approach is 79%. That's a whole lot better.

I've been saying this on the last few trades that just because the reward/risk is better doesn't mean it is a better trade. I've been observing recently that in this turbulent market there are a lot of trades that have been closed with the 2x rule that would have ended up profitable had I remained in. However that also is no reason to shift strategies necessarily because when I am wrong, it cost me a lot more (usually the entire risk amount).

I say all of this just to make the point that there are many ways to manage a credit spread exit but each has its own set of advantages and disadvantages. Just know what characteristics you are looking for before making a choice. I'll be looking at this in more detail in a future newsletter.

Position sizing

When I size my position, I want to make sure that the risk I assume in the position is no larger than my trading rules allow for each trade. I've established a rule to risk no more than 2% of my portfolio on any one trade. My current portfolio is $18,677 so 2% of that would be $373 that I can risk in this trade.

In the prior section I already talked about the rule I employ to limit my risk. In this credit spread trade, I'll be limiting my risk to just $.48. That means I can sell just 7 contracts and remain within my risk tolerance.

Exit plan

I've already talked about most of my exit rules for the credit spread trades I take. I have a rule to lock in profit. I have a rule to limit my loss. Finally, I have a rule to ensure I'm out of the trade regardless by the last week of the option cycle. This is due to the fact that gamma for near the money options gets really high and causes option prices to get crazy.

Just to summarize then, I will exit under the following conditions.

  1. I will exit when it costs $.96 to close - That will limit my loss to just $336, which is within my trade risk tolerance.
  2. I will exit when I can do so for $.10 - This will lock in a profit of $.38 per contract or $266 as my target profit.
  3. I will exit when approximately 4-5 days of expiration

I usually mention this on each of my trade tutorials but I prefer to use my trading platform to enforce my first two rules. Most platforms support OCO orders and many platforms allow you to place a 'stop' order on a spread. Check with your broker or consider switching to thinkorswim if your broker doesn't support this.

credit spread trade management

The above snapshot shows both orders in place in the form of an OCO order that locks in my 80% profit or limits my loss to the initial credit. Above I say it is a 2x limit but the first $.48 pays back the original credit leaving me with a loss of $.48.

Portfolio Impact

Since my overall outlook is bullish, I want to begin to skew my delta accordingly. The last trade I entered merely served to offset the negative delta of the remaining call spread I have from the iron condor on the DIA.

credit spread portfolio impact

This credit spread adds more delta and you can see that the overall portfolio delta is now positive. In addition the trade has added positive theta, which means more time value of the premium is melting away. These are the kinds of trades I prefer to have on.

Update 11/3/2010 (Closing Update)

This trade has been on for just about a month and has gone off smoothly. When a trade goes as smoothly as this one, there isn't much to say. It's nice when a trade goes as planned.

I'll conclude this update with a summary of the trade. I entered this trade for a credit of $.48 and closed the trade for a debit of $.10 leaving a net profit of $.38. I sold 7 contracts, which make $266.

This trade had a risk of $336 ($.48 x 7 contracts x 100) because I had a stop order in place to limit loss. That means my return on risk is 79%. Keep in mind that the broker still holds the full potential risk in margin. Since I sold 7 contracts of a $2 wide spread, I had $1400 of margin held. You could think of this as amount invested since that is cash that is tied up while the trade is open. That means my return on investment is 19% (266/1400).

It's nice to have a few successful trades in. As long as the market continues to show bullishness or even consolidates for a while, I should see the other put spread close successfully as well.

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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