Trade Tutorial - Put Credit Spread (12/20/2010)

With the ongoing bullishness, I'm going to enter another put credit spread. This time on the XLE, which has shown surprising strength of late.

Credit spread trade on XLE

Sell XLE 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 $.40

Why this strategy?

In the next newsletter I'm going to talk about using technical setups to create optimal trade entries. This is an example of just such an entry. The XLE has shown a nice move up, a slight pullback and now has pushed through the recent high. It's a bit chancy to enter without a solid close, but the overall market was showing strength so it seemed like a reasonable risk.

The nice thing about this setup is that there is a clear break of resistance and a move to a higher high, which is a nice bullish indication. Ideally it happens on increased volume but in a holiday week, even average volume is a decent indicator.

Since we have a nice bullish entry, the next decision is the strategy. Of bullish strategies, there's the put credit spread, call calendar or call diagonal spread. I've listed these in order of typical trade duration. I wouldn't say at the moment I'm bullish longer term since we are heading into the beginning of a new year. As a result, I'm inclined to select a strategy with a shorter duration, which would be the credit spread.

Choosing the right strike prices

Now that I have selected a strategy, I can now employ the trading rules for that strategy. The trading rules for the credit spread call for selecting a short strike having a probability of expiring ITM of 30-35% and having at least 20 days until expiration. That means I'm looking at a January $65 put as the short strike.

credit spread strike selection

Since I often trade $2 wide spreads, I will be buying a $63 put to limit my risk. A $2 wide spread only has $2 of risk. Since I'm looking at $.40 credit to enter the trade, my actual risk is only $1.60.

Risk/Reward analysis

I've already outlined the risk and reward on this trade. The risk/reward ratio is 25%. That may seem like a low reward/risk ratio. However another way to look at this is that I'm tying up $1.60 of my own money in margin for the possibility of making $.40. In that context I'm talking about return on investment of 25%.

In past trades, particularly credit spreads, I've employed a technique of limiting risk by closing the trade early if I reach a point where my loss amount equals the initial credit. The objective of this kind of exit rule was to limit my risk in order to take a larger position size. The idea behind this approach was that when I have a successful trade I make more. However the risk has been that I'm stopped out of more trades, which means I have more losing trades.

As I've mentioned in recent trades, my plan in 2011 is to simply position size based on absolute risk rather than the loss limiting approach I've used in the past year. I'm going to commit to this approach for the duration of 2011 and we'll compare results at the end of the year.

Position sizing

In every trade I do I'm only risking 2% of my portfolio. If you go back and look at t number of failed trades in 2010, you begin to realize the benefit of money management. In this case, my portfolio is currently worth $16,991. That means I can currently risk $339. With a risk of $160 per contract, that means I can sell 2 contracts.

That doesn't seem like a lot, however if more trades are winners, the overall result will be a slow increase in my account.

Exit plan

While it may seem like the removal of my typical exit rule will result in fewer exit rules overall. However, I will be exchanging my loss limiting rule for more technical exit rules. Just as I used technical analysis to time my entry, I will use technical analysis to exit as well.

My rationale for entry was a bullish breakout over the prior resistance area. As old resistance should become new support, a fall back below this level (around $66.68) should signal an alert condition. If XLE were to fall below $65, I'd consider the analysis failed.

So what of my rule to lock in 80% of the initial credit? I think for now I'm going to stay with this rule. Over time I may alter this rule but for now, let's alter only one thing at a time.

In summary, I will exit under the following conditions.

  1. I will exit if XLE falls below $75, which is a clear change of trend.
  2. I will exit when I can do so for $.08 - this will lock in a gain of $64
  3. I will exit when approximately 4-5 days of expiration

Portfolio Impact

This is a bullish trade in an overall bullish market. As such, I wouldn't be surprised for this trade to add positive delta.

credit spread portfolio impact

The other advantage of this the credit spread is the positive theta it adds to the portfolio. In this case, the position size is smaller so the theta added is a little smaller.


Update 1/11/2011 (closing update)

Another textbook trade. This trade went exactly as expected and in fact with the strong market open, filled at $.05.

Just a few short weeks after entering this trade, we are out. I entered this trade for a credit of $.40 and closed for a debit of $.05, which makes the net credit $.35. I sold just 2 contracts in keeping with my new trading rules concerning credit spreads. As a result, the profit in this trade is $70.

That doesn't seem like a lot compared to some of the trades I entered last year but my expectation is that I'll have more winners because I can stay in longer. Time will tell on this.

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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