Trade Tutorial - Put Credit Spread (12/29/2011)

I'm entering a put credit spread as my last trade of the year. I was hoping to enter a little sooner than this but all the year end busyness conspired to prevent that until now.

Credit spread trade entry

Trade
Sell SPY 123/121 put spread
ROI
29%
Exits
1. Exit if I can lock in 80% of my initial credit (i.e. $.09)
2. Exit if within 4-7 days of expiration
Credit $.45



Why this strategy?

As you can see in the chart above, it appears as though we are seeing a series of higher lows. However, the highs have remained largely about the same, maxing out at around $127. Some technicians would argue that this is an ascending triangle chart pattern, which is bullish.

What I notice from this chart is that it seems to respect the fibonacci retracement I put down that measures the retracement from the high established back at the end of October to the low set at the beginning of October. So, in the course of that month, the SPY moved over $20 (that's 200 S&P points). It then retraced 61.8% of that move, returned to near the highs and then retraced 38.2%of the original move before heading back to the highs.

While it's possible that this trend could fail, this has the markings of a powerful setup for a bullish move to start the new year. As a result, I'm entering one last bullish (short term) trade for the year.

Choosing the right strike prices

For the credit spread strategy, I usually look for my short strike to have a probability of expiring of somewhere between 30-35%. This means that I have a 65-70% probability that the trade will expire worthless. In addition, I look for an option series that has somewhere between 20 and 30 days until expiration to provide plenty of time premium.

credit spread strike selection

As the capture above shows, this equates to the $123 January put. One of the recent effects of the bullishness is the volatility has dropped, making overall premiums a little smaller. As a result, I've taken to being more aggressive - targeting 35-38% probability of expiring. That's a slightly riskier trade in the sense of probabilities but that's somewhat managed by closing the trade early.

As usual, this is a $2 wide spread so I will also select the long Jan $131 put as a protection that limits my absolute loss if everything goes wrong.

Risk/Reward analysis

The credit for this trade was $.45. With a spread that is $2 wide, the maximum I could lose is the width of the spread ($2), but since I received $.45 in premium to sell the position, my actual risk in the trade is $1.55.

credit spread analysis

I don't often include a P&L graph such as the one above in these trades as they pretty much always look the same for a given strategy. However, I do want to take some time to review the characteristics of a credit spread. In this case, the red line shows the absolute P&L at option expiration. At that time, there will be no premium  value associated and the option will either have intrinsic value or it won't. On the other hand, the current P&L characteristics are much flatter. That's because the options currently have a lot of premium (extrinsic value) that needs to melt away.

At any rate, with a max gain of $.45 and a max risk amount of $1.55, my reward/risk is 30%. That is with an overall probability of success of about 66%. Remember, I got that value from the selection of my short strike. That assumes I let my trade run until expiration. Those that follow these tutorials know I rarely ever do that. My exit plan calls for locking in 80% of the profit, which would be about $36, yet my total risk amount remains $1.55 so my new reward/risk is 23%.

Why would I consider taking a lower reward/risk amount? Because by closing early & locking in a lower profit, my probability of success goes up. It's difficult to put an actual measure on this but any time we can close a trade in less time, our probabilities will be better.

Position sizing

I have a trade that will expose me to $1.55 or $155 per contract in risk. My rule for position sizing is to risk only 2% of my current portfolio, which is currently $16,929. That means I can risk just $338, which is only 2 contracts. It would be nice to take a larger position for the gains it would return but that's too much risk.

Exit plan

My exit rules for a credit spread are now pretty simple. I will exit to lock in 80% of my initial credit and I will exit absolutely before expiration. See this discussion to know why.

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

  1. I will exit when I can do so for $.09 - This allows me to lock in 80% of the initial credit, leaving me a target net profit of $.36 per contract or $76.
  2. I will exit when approximately 4-5 days of expiration

Portfolio Impact

I started with an empty portfolio so this trade will be the only one so far. This put credit spread is a bullish trade so it's no surprise that I have a positive delta. It's only mildly so because even if the market went sideways from here, it would be profitable simply due to the theta (time erosion).

credit spread portfolio impact

Almost all my trades are positive theta trades. Check out this list of other positive theta trades. This number is fairly small right now but will get larger as we get closer to expiration.

Update 1/13/2012 (Closing Update)

Wow! I happened to check on my trade and realized there was no closing exit. I suspect what happened was that I entered the closing trade to lock in my 80% but forgot to change the order type to 'Good Till Cancelled' instead of a Day order. As a result, it cleared out at the end of the trading day.

That was lucky for me as I ended up closing the trade for $.05 debit instead of my intended $.09. As a result, the net profit per contract is $.40 or a total net profit of $80. That doesn't seem like a lot, but let's look at the big picture.

I sold two contracts of this spread for a total credit of $90. That leaves a maximum risk of $310. Since I actually locked in $80 in profit, my return on risk would be 25%. When we look at the return in that light, it seems like a really nice return.

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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