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Trade of the Week - Put Credit Spread (12/21/2009)

I'm learning my lessons - in this case not to fight the trend. This is a put credit spread (or short vertical spread) on the SPY.

Credit spread trade setup

Sell SPY 109/107 put spread
1. Exit if I can lock in 80% of my initial credit (i.e. $.08)
2. Exit if cost to close >= twice initial credit (i.e. $.80)
3. Exit if within 4-7 days of expiration
Credit $.40

I've been convinced that this rally wouldn't last and that conviction has cost me some money in failed trades and lost opportunities. I'm just going to traded the trend and see where that gets me.

Why this strategy?

After chopping around for a while consolidating around the $111 level, SPY is starting to show strength again. I think this is a good time to be putting on bullish trades like the put credit spread. When I'm reasonably bullish, this is the first trade I think of. 

Why? Because it's a pretty basic strategy, it has a pretty high success rate and it's easy to plan for the best and worst case scenarios.

Right now, I like trading the SPY and DIA because with the volatility as low as it is, I still can get a reasonable credit on the trade. As those who have followed these trade tutorials know, I prefer to trade ETFs for the most part.

Choosing the right strike prices

I'm usually looking to sell a short strike with a probability of success of 65-70%, which means I'm looking for a short strike with a probability of expiring in the money by a penny or more of 30-35%. 

Credit spread strike selection

I also want to make sure there is enough time in the month I'm selling. With volatility low, that means I need at least 25 days and 30 would be even better.

With those criteria in mind, I've selected the 109 strike to sell. I tend to sell $2 wide spreads so the long strike will be $107.

Position sizing

As I mentioned, one of the reasons I like this trade is that planning exits and position sizing is pretty straightforward... at least with my trading plan.

I know that if I take in $.40 credit for the trade, I'll close it when the cost to purchase it back cost twice the credit or $.80. That means for each contract, I have $40 in risk. 

I've been risking 2% of my portfolio on each trade. Right now, my portfolio basis is still around $20,000 so 2% would be $400. With $40 risked on each contract, I can sell a maximum of 10 contracts and stay within that limit. I've sold 9 contracts.

Exit plan

I will exit under the following conditions.

  1. I will exit when it costs $.82 to close - that's just over twice the initial credit, which means my risk is $.42 * 9 contracts
  2. I will exit when I can do so for $.08 - this locks in a profit of 80% of the initial credit
  3. I will exit when approximately 4-5 days of expiration

As always, the best way I know to ensure that rules 1 & 2 get followed explicitly is to set a stop. I can do this on the Thinkorswim platform quite easily. To see this demonstrated, check out this tutorial.

Credit spread trade exit

Here are those two rules set up as a 'one cancels other (OCO)' order. One represents my target profit point, the other my max loss point.

Portfolio impact

This credit spread adds a fair amount of positive delta to my portfolio.

Credit spread portfolio summary

That's not such a bad thing if I'm bullish. Notice right now, I have a position that has a fair amount of negative delta. That's the remainder of my calendar spread on DIA, which is now only a long put.

Unless I see a trend reversal coming, I'll probably put on more bullish positions in the coming weeks.

Update 01/05/2010 (Closing update)

That was a pretty quick trade. Given the holiday frenzy, I didn't even get a chance to put up an update.

I'm out of this trade as of yesterday with my limit order triggering at $.08 and my stop order being canceled. That means I've locked in a profit of $.32.

The final ROI on this trade is 20%. That's $.32 divided by my initial max risk (or margin in the trade) of $1.60.

Since I sold 9 contracts, that's a final net profit of $288. That's a pretty nice start to the new year. Credit spread trades have been pretty good to me overall, which is why I use this strategy more than any other.

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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