This trade is a put credit spread (also known as a short put vertical spread). Actually, I'm putting on two of them. I'll explain why in a minute. First, take a look at this portfolio analysis graph (beta weighted to the SPY) and see what it indicates...
2 Dec EWZ 77/75 put spreads
Sell 2 Dec/4 DIA 103/101 put spreads
||1. Exit if
close >= approx twice initial credit (i.e. $1.00)
2. Exit if within 4-7 days of expiration
The above analysis graph is a composite of my portfolio. At a quick glance, it indicates that my maximum profit point would be when SPY sells off to $101.79 (about a $10 point sell off). It also indicates that the current price is near the upper break even point. The other thing I want to point out is the current effective delta of the position. It is pretty heavily weighted toward the bearish side - meaning I'd benefit from a bearish move.
Given that my portfolio is pretty heavily bearish and there is a strong risk that the market could continue a bullish trend, I wanted to add some bullish bias to the position. I can do this a number of ways.
Keep in mind, any adjustment I do must meet the following criteria.
With these criteria in mind, one of the obvious choices is a put credit spread, also known as a vertical spread. It is positive theta, defined risk and if I size the position correctly, won't add excessive risk to the down side.
I decided rather than putting a whole trade on one product, I'd put on two different trades on different instruments. I'm choosing EWZ and DIA.
I started out building this trade with a put credit spread on EWZ partly to offset the risk of my calls I currently have on there being overrun. I currently have 4 contracts of the call spread and I chose to only add 2 contracts of the put spread (again, sticking with my rule of not adding excessive risk in the opposite direction).
As I usually do, I try to find a short strike with a probability of success of around 65-70% and selling a $2 wide spread. For the EWZ position, I found the Dec 77/75 put spread for a credit of $.49.
For my second choice, I went with the DIA simply because I had just the calendar spread on there and it looked like a good opportunity to offset some of the risk there. When I looked at December options, there wasn't too much premium value left in them for the risk they would introduce. I chose instead to go with Dec quarterly options, which expire about 2 weeks later. I ended up with a 103/101 put spread on DIA for a credit of $.48.
For this particular set of trades, my position sizing isn't so much based on the typical trading plan I use for a credit spread. Instead, it's driven largely by my rule #3 above when putting on a trade adjustment.
As I mentioned, I had 4 contracts of a EWZ call spread so I want to put on a large enough position to make a difference but not add more risk in the opposite direction. I chose to go with a size of 1/2 my call spread position size, or 2 contracts. At $49 credit, that leaves $302 in risk to the downside if I don't take any action. However, my risk in the existing trade is currently only $176. As a result, I'll want to look at an early exit (like 2x the initial credit).
On the DIA credit spread, I decided to simply put another 2 contract trade on there just to add more positive delta. With a credit of $.48, my downside risk is $304 but this is offset by the fact that my max profit on the calendar if the market sells off that far would be about the same. Regardless, it would be good to reduce this risk by closing early.
Overall, my plan is to remain in these trades all the way unless either one hits a stop price where I need to get out to cut my risk. In this case, I'll exit the DIA credit spread if the cost to close reaches $1 (that's just over $100 risk). I'll follow a similar rule for exiting the EWZ, which have a similar risk amount.
The net impact on my portfolio is to reduce my delta from -135 to -78.
Overall, the change isn't huge, but I've added some additional premium potential and reduced my negative delta somewhat. If the market starts to break through the consolidation that has built up over the last few weeks, the best overall adjustment is probably to close the bearish trades altogether and put on some more bullish trades.
This adjustment trade, which are two small credit spreads is hanging in there. These were bullish put spreads to offset the overall bearish bias my portfolio had.
As of today, they are doing ok. In fact, I am sitting right at the center of the small profit bump at around 111 on the SPY. I would actually prefer a stronger selloff to put the SPY down around the 104 or 105 range. On any indication this is happening I would be closing these credit spreads so the graph isn't entirely accurate.
At this point, I'll be watching for an opportunity to close the EWZ put spread since this is expiration week for those contracts.
I closed the EWZ put spread on expiration Friday for a debit of $1.90. I actually made a mistake on this one I think. I should have been monitoring and and exiting much earlier since my plan was to exit for around $1.00.
At any rate, I took in $.48 so my actually loss amount was $1.42 times two contracts or $284.
I just closed the DIA spread for $.06. If I look at these two trades in total, I have a net loss of only $.99 per contract about $198.
I'm still not happy with this trade, not because I lost money, but because I didn't follow my exit plan. Had I done so, the two trades together would have been roughly a break even.
So, why didn't I exit as planned? For one thing, I didn't have an order in to do so... something I usually do. Second, I wasn't watching this trade as closely as I should with other distractions going on heading into the holiday season... even more reason to have put in a mechanical stop.
The irony of this trade is that it was designed to hedge against the risk of the market moving up. The trouble is that the market didn't really go up or down... it just muddled around for a few weeks. On top of that, EWZ suddenly started showing relative weakness.
Rule # 1 - Don't lose money.
Rule # 2 - Never forget Rule #1 (Warren Buffet)
Stay tuned for further updates as the trade progresses...