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Trade Tutorial - Put Credit Spread (11/29/2011)

It's time to put on another trade and this one is my favorite credit spread. I put this trade on a few days ago but am just now getting to the trade write-up.

Put credit spread trade setup

Sell DIA 110/108 put spread
1. Exit if I can lock in 75% of my initial credit (i.e. $.11)
2. Exit if within 4-7 days of expiration
Credit $.45

Why this strategy?

Besides being flat on my account, it's starting to look like the market is going to head for another leg up. The last week or so has shown a sizeable sell-off. The first few days after the Thanksgiving weekend showed a nice little bounce. While not a certainty, it's looking like this will either be a nice bounce or a failed one.

Given the fact that this bounce may be rather short lived, I'm going for a fairly short term trade as I'm not sure how long the rally will last. There's a good chance this trade can return a profit and we'll be out before there is another reversal.

Choosing the right strike prices

As usual, I'm looking for a short strike having a probability of expiring (ITM) of around 30-35%. Given the shorter duration, I'm going to take a slightly more aggressive position, that is one with a slightly higher probability of expiring ITM.

As I usually do for a credit spread trade, I'm going to select a long strike that is $2 away from the short strike. This long strike acts as protection limiting my maximum loss to $2. However, I received a credit of $.45. That means I have a maximum loss amount of $1.55.

The plan is to be in, lock in a profit and be out in a fairly short period of time. As such, I'm going to adjust my target profit point. I usually target locking a profit of 80% of the initial credit. In this case, since I've taken a more aggressive position, I'm going to settle for 75% of the credit. This amounts to $.37, which means I'll have a target close price of $.12.

Risk/Reward analysis

This trade has a target max profit of $.45 and a maximum loss amount of $1.55. That mains my absolute reward/risk ratio of 29% (.45/1.55). However, since I plan to close the trade for a target profit of $.34, which means my actual reward/risk if this trade works out will be 21%. While that seems like a worse plan than letting the trade play out, the probability of success improves because I'm not letting the trade run.

Position sizing

Every trade I enter has one thing in common and that's that I will limit my risk to just 2%. To begin, I take my current portfolio value ($16,861) and multiply by 2% and arrive at a risk for this trade of $337. I will then divide that amount by the risk per contract of $155 and arrive at 2 contracts that I can sell and remain within the risk threshold.

Exit plan

As I mentioned earlier, my plan for this credit spread is to exit a little earlier than usual. As a result, my target debit to close will be $.11. As a result, I have only two exit rules for this trade.

  1. I will exit when I can do so for $.11 - This targets locking in a profit of 75% of the initial credit or $.37.
  2. I will exit when approximately 4-5 days of expiration

Portfolio Impact

I started this trade with a flat portfolio. I'm entering a bullish trade so it's no surprise that the resulting delta from entering this trade is positive as the below chart indicates.

In addition, the theta is positive even if it is a little small at the moment. The thing about theta is that it will grow as the trade reaches expiration.

All that's left for this trade is to sit back and let the trade run for the next few weeks. With any luck, we'll be out by Christmas.

Update 12/10/2011

A little more than a week after entering this trade, we're nearly out. Not that the recent action of the DIA has given us any reason to relax. The day after entering the trade, the market in general popped up but spent the next week consolidating. Will we be out of this trade or see it put at risk?

That's the real question as we head into the next few weeks. My bet is we see buying into the end of the year. If so, this trade will likely close in the next week or so as there's only about $.10 or more to bleed out before we hit our target exit price.

Update 12/21/2011 (Closing update)

Woops! With the Christmas break and everything, I forgot to write up the closing summary for this credit spread trade.

I closed this trade per my standing limit order officially on 12/21. This trade closed profitably as planned. Other than the ups and downs we've come to expect of the market, this trade went pretty much as expected. Let me run down the numbers.

I entered this trade for a credit of $.45 and sold two contracts of this spread. I chose to close the trade a little earlier to lock in my profit and raise the probability of success. As a result, I closed for $.11 debit for a net profit of $.34. Since I sold 2 contracts, my net profit overall is $68.

That's not too bad for this trade, especially if you consider the market turmoil that we've experienced. What I'm considering more and more these days is the phrase "there's nothing wrong with taking profits". The more turbulent the market, the more willing we need to be to simply take profit and get out. In other words, we need to be willing to adapt our strategies to the times we're trading in. As long as the market remains turbulent, it may be better to settle for less profit if more trades are successful.

Rule # 1 - Don't lose money.
Rule # 2 - Never forget Rule #1  (Warren Buffet)

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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