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Trade of the Week - Put Credit Spread (10/19/2010)

I'm entering another put credit spread. I had intended to look for a bullish diagonal spread but the premiums were a bit rich for the account size I'm currently trading.

Sell SPY 115/113 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. $.94)
3. Exit if within 4-7 days of expiration
Credit $.47

I would have liked to have entered a diagonal spread on the SPY, but it turned out to be be a little more costly to enter. As a result, I'll start with this credit spread.

Why this strategy?

As I mentioned a few weeks ago, I was looking for some signals to indicate continued bullishness. As it turned out, the consolidation and then push up above $116 was enough for me.

There are many different bullish strategies that might work in this situation. Each has it's own characteristics and benefits. For example, the diagonal spread I mentioned earlier can be a nice trade in a bullish environment. However, as I also mentioned, the cost to enter this kind of trade can be a little higher than other types of trades. Also, it is a longer term trade and isn't yet clear that this trade will continue. On the other hand, the credit spread is a nice bread and butter trade that doesn't cost nearly enough to enter but works well even if the market trends sideways.

I will probably be entering another bullish trade very soon but for now, this is a nice little income generator. By the way, I will be talking about strategy selection in more detail in the next newsletter coming in just a few weeks.

Choosing the right strike prices

The trade plan for the credit spread calls for selling a short strike with at least 20 days until expiration and a probability of expiring between 30 and 35%. That would mean a probability of the short strike expiring worthless of 65-70%.

In this case I'm looking at selling a November $115 short put. This is slightly more aggressive than I usually take but then I'm a little more bullish. Since I often trade $2 wide spreads, I would also buy a $113 put to provide risk protection. This trade will pay $.47 credit.

Risk/Reward analysis

Since I have a $2 wide spread with a $.47 credit, I have $1.53 in risks. On the surface, that would equate to a reward/risk ratio of 30%. That's not bad but my exit strategy results in a slightly different risk amount.

My exit strategy calls for closing the spread if the cost to close reaches an amount of 2 times the initial credit. That means my risk in this trade amounts to just $.47. My exit strategy also calls for closing the trade when I can lock in 80% of the initial credit. That means my reward will only be $.38. In this case, my reward/risk ratio is 80%.

Position sizing

I've already mentioned my exit plan, which results in limiting my loss to just $47 per contract. My trading plan calls for limiting my risk per trade to just 2% of my current portfolio value. At the moment, that value stands at $16,896. That means I can risk $337. Since the risk in this trade is $47 per contract, I can sell 7 contracts and remain within my trade risk threshold.

Exit plan

As usual, most of my exit rules have already been covered. I have a rule to lock in profit, a rule to limit loss and finally, a timeframe rule. I always make sure I'm out of the trade before expiration day. My rule is to be out within 4-5 days before expiration.

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

  1. I will exit when it costs $.94 to close - This will limit my risk in the trade to an amount equal to the initial credit.
  2. I will exit when I can do so for $.09 - This will allow me to lock in 80% of the credit for a total gain of $266
  3. I will exit when approximately 4-5 days of expiration

On the thinkorswim platform I can execute my first two rules using a OCO (one cancels other) order.

Notice that on the loss limit order, the type of order is a stop order. Not all platforms support stop loss orders on spreads. Check with your broker to see if they support stop orders on spreads.

Portfolio Impact

I put this trade on due to my bullish outlook. As one would expect, this credit spread should add additional positive delta to the position while also adding additional positive theta.

As we can see, the delta is now quite a bit higher as a result of this new credit spread on the SPY. We also now have additional time premium melting away, which is the ideal scenario for the kinds of trades I like to enter.


Update 11/4/2010 (Closing update)

Another textbook trade, due mainly to the ongoing bullishness of the market. This trade closed shortly after the market opened with a gap up.

This trade was on for even less time. I first entered on Oct 19 and am out just over 2 weeks later. Let's take some time to look at the results of the trade. I entered for a credit of $.47 and closed with a debit of $.09 leaving a net gain of $.38 per contract. I sold 7 contracts, which makes a net profit of $266.

While it's often easier to draw lessons from the failed trades, I want to take a moment to look for some lessons learned in the midst of this successful trade. Every successful trade starts with a good trading plan regarding how and when to enter. However a successful trade is further assisted by having a set of clearly defined exit rules - both to limit loss and lock in profit. Furthermore, I consider this a successful trade because it was entered based on sound money management rules that helped ensure that I wouldn't suffer a severe loss if the trade went against me.

I mentioned in the newsletter that I may start looking for some bearish trades. However I want to make sure the recent round of buying has dried up before taking such a position.

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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