Trade Tutorial - Put Vertical Spread (3/23/2012)

We may be seeing a good vertical spread entry opportunity with this recent pull-back. Check out the chart below. We are looking at levels not seen since 2007!

vertical spread trade analysis

Sell SPY 138/136 put spread
1. Exit if I can lock in 80% of my initial credit (i.e. $.10)
2. Exit if SPY falls below $138.50

2. Exit if within 4-7 days of expiration
Credit $.47

Why this strategy?

As I've mentioned from time to time, the vertical spread (or credit spread) is my go-to strategy, especially for shorter term trades. Let's look at what's been going on lately with the SPY. First of all, I mentioned at the beginning of this tutorial that the SPY as at levels it hasn't seen since late 2007. Notice that as of a few days ago the SPY approached overhead resistance and then suddenly pulled back.

Psychologically, that was many traders saying "Ok, time to take profit". And so, selling took place for nearly a week until an apparent floor was established today. Notice that this is not an absolute but is a reasonable indicator that we may see a resumption of buying, perhaps even to break through the resistance level of about $142.50.

Given my short term bullish outlook, I'm favoring this put vertical spread as a good trade for the moment. If we break through the resistance level and sustain it, I may look for a longer term bullish strategy.

Choosing the right strike prices

As I've said with almost all my vertical spread trade tutorials, the strategy for strike selection is to find a short strike in an option month having 20 days or more until expiration and having a probability of success of between 65-70%. The thinkorswim platform recently added the ability to show probability of expiring OTM, which is the same as probability of success for any short vertical spread strategies.

vertical spread strike selection

Notice in this case I took a slightly more aggressive position. The reason is that as we get closer to the 20 cutoff and the volatility remains relatively low, the premiums are not as good. That said, I was confident in this position because it still below the pivot point established when the SPY reversed.

To compensate, I'm going to insert an exit rule to get me out of the trade if the SPY drops below $138.50. Why? Because this would establish a lower low, which is a bearish indicator.

As usual, I will select the long strike $2 farther OTM making this a  $2 wide spread entered for a credit of $.47.

Risk/Reward analysis

With a $.47 credit on a $2 wide spread I have $1.53 in risk. My risk/reward calculation (or return on risk) would be 30%. That's a little lower than usual, especially given the the lower probability of success. However, remember I will be managing this additional risk by inserting an early exit rule to stop me out if I'm wrong. That makes it a little harder to calculate since I don't know how much this will reduce my absolute risk.

One other strategy I always employ on my vertical spread trades is closing the trade when I can lock in 80% of the credit. That means I'll pay 20% of the credit back to get out of the trade. In this case, I will close the trade if I can do so for a debit of $.10 (I rounded up to the next penny), leaving a net profit of $.37. That makes my projected return on risk .37/1.53 or 24%.

Position sizing

I know my absolute risk in this trade, which is $1.53. As with every trade I take, I never risk more than 2% of my portfolio. My currently portfolio is at $17,363, which means I can risk $347 in this trade. With a risk of $1.53 (or $153) per contract, I can sell 2 contracts and remain within my risk tolerance.

So, selling 2 contracts with an exit plan to lock in a net profit of $.37 means my target profit in this trade is $74.

Exit plan

As I mentioned earlier, I have two standard exit rules but I'm adding an additional exit rule to get me out of this trade if the recent pivot is not an indicator of resuming the up trend. A break of this support level means I'm wrong and I should get out and look for another trade opportunity. I'll implement this as an OCO as was illustrated with the last trade I entered.

To summarize, I will exit under the following conditions.

  1. I will exit when I can do so for $.10, which will lock in a target profit of $.37 per contract or $74.
  2. I will exit if the SPY breaks below $138.50, which is an indicator of this trade being wrong.
  3. I will exit when approximately 4-5 days of expiration

Portfolio Impact

This portfolio has been flat for about a week now so this vertical spread will be the only trade on. As such, it's no surprise that a bullish trade results in a positive delta. That really means two things. First, that the trade will benefit from a move up in the overall market, but particularly in the underlying (SPY). Second, that if the SPY were to gain $1, this trade will gain in value $23.

vertical spread portfolio impact

This doesn't even take into account the effect of time passing. As a result, the spread is losing $.54 per day (approximately) even if nothing changes but the passage of time. As the introduction to spreads video illustrated, the greeks interact with each other though, so it's hard to put know exactly how the price will change when time is passing, the SPY is moving up and volatility is dropping.

Update 4/9/2012 (Closing update)

The OCO order I had in triggered an early exit when the SPY dropped below $138.50. Sorry, I forgot to provide the closing update on the trade.

When I entered this trade, I said I had a short term bullish outlook. I had anticipated the SPY moving up to the $142 area and perhaps pausing but also considered the possibility that failure to break through might trigger another round of profit taking.

I entered this trade for a credit of $.47 and closed out when the stop loss triggered for $.68 debit. That's a net loss of $.21 per contract or a total loss of $42. That's not too bad for a trade gone wrong.

As it looks now, placing the stop loss order to protect from further potential loss was a good idea. Any time there are good technical reasons to exit a trade early, I believe it makes sense to do so. Having a trading rule in place ahead of time makes it much less of an emotional decision. In fact, because it was simply a OCO order, the decision to close was pretty much made for me.

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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