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Trade of the Week - Put Vertical Spread (4/22/2010)

This is a bullish call vertical spread on the IWM. I have gone from fairly neutral to fairly bullish over the last few weeks as this insane market climb continues.

vertical spread on the IWM

Sell IWM 72/74 call spread
1. Exit if I can lock in a nice 40% return on my initial cebit (i.e. $1.77)
2. Exit if the trade loses 1/2 it's value (i.e. $.63)
3. Exit if within 4-7 days of expiration
Debit $1.27

The market in general has been on an insane run and the IWM (the ETF that follows the Russell 2000 index) is showing even more relative strength. Normally, I would trade a bullish put spread but in this case, I'm going to go with a long vertical spread (also known as a debit spread).

Why this strategy?

If short vertical spreads have worked so well, why switch up? I actually have several reasons.

First of all, since these trade tutorials are designed to be instructive, I wanted to do a trade that is functionally equivalent and yet has some different nuances.

The main reason I consider this kind of trade is that it allows me to be a little more aggressive in my trade position. In the above chart, we can see that IWM has just broken out for the second time above a support level. As such, I felt it was time for a trade that could benefit from a larger move and offer a little more of a benefit in the process.

My forecast is for IWM to push up through $74 and remain there for some time, perhaps even continuing to move higher. I could sell a $74/72 or $73/71 put spread but that can be a little risky because my short strike could at times be ITM which carries a risk of assignment.

As a result, I decided to buy the equivalent in the $72/74 call vertical spread. Instead of receiving a credit up front and then closing by giving some of the credit back, I'll enter with a debit and receive my net credit at the end of the trade.

I want to point out that while the trade itself is somewhat similar in behavior to its short vertical spread equivalent, the trading plan I follow is quite different.

Choosing the right strike prices

When I trade the long vertical spread, I usually choose my strike prices a little differently. In essence, I use this kind of trade as an alternative to a long call. While the maximum gain is limited, the cost to enter the trade is also much smaller.

Given that, I tend to choose my short strike based on my forecasted price for the underlying. In this case, I'm taking a mildly bullish stance by determining that I expect IWM to remain above $74 through expiration. As a result, I'm willing to sell an OTM call at $74.

Vertical spread strike selection

Since I tend to trade $2 spreads on these ETFs, a logical long strike would be the $72 call. The price of this trade at the time I entered was $1.27. That means my potential max gain will be $.73 and the trade will have a target ROI of 57%. Usually on this kind of trade, I look for an ideal ROI of at least 60% but we're starting to get into the time window where May options aren't paying that well.

Nevertheless, I'm going to go ahead with this trade. The potential return is decent enough and I'm going to exit once I'm able to lock in a 40% ROI.

Risk/Reward analysis

It's important to consider the worst possible scenario as well as the best case scenario. I've already considered what this trade could make if IWM behaves as expected. What would happen if if IWM sold off heavily? I could potentially lose my $1.27 debit. Depending on how quickly I acted and how far IWM sold off, I could potentially exit and retain some of the value. However, without a plan, taking action is difficult to do. Let's take a moment to consider one exit plan for the worst case scenario.

Just to review... On this trade, the maximum risk in the trade is the debit I paid, which is $1.27 per contract. My maximum gain will be the width of the spread ($2) minus the debit or $.73. Is there a way I can minimize my risk on this trade?

I could close the trade early using a loss limiting strategy. For example, I could exit when the trade loses 1/2 the initial debit value. That would mean my risk in the trade would be limited to approximately $.63.

Position sizing

Like any strategy I follow, I make sure I determine the size of my position based on the maximum loss I'm willing to tolerate on the trade. Each trade I take I risk 2% of the current portfolio value, which is at $19,214. That means I can only risk $394 on this trade. If I go with my early exit plan of limiting the loss to $.63, that means I can take  right at 6 contracts.

Exit plan

My exit plan for this strategy is to close the trade when I can lock in a 40% return on my initial $1.27 debit. That means I will close when I can sell the spread back for $1.77. Also, since I sized my position for a limited loss, I need to ensure I close the trade if it ever diminishes in value to $.63. As I do in all my trades, I also will close the position 4-5 days prior to expiration.

As a less absolute exit, I could consider an exit if the IWM broke down through the old resistance level at around $72.50. This is going to be a lot more difficult to measure. By how much? For how long? I'm going to suggest that a break of this level on above average volume might be a signal to exit early if my stop hasn't already triggered.

Just to summarize...

  1. I will exit when I can sell the spread for $1.77 (my ideal scenario)
  2. I will exit if the value of the spread drops to $.63 (my worst case scenario)
  3. I will be watching the technical level of $72.50 for a significant break
  4. I will exit when approximately 4-5 days of expiration

As I've mentioned before, I tend to set the first two exit rules up a s a combination one-cancels-other (OCO) order. In this case, I'll either automatically trigger a limit order to close at $1.77 or trigger a stop order to close at $.63.

Portfolio Impact

While this trade is somewhat different than a lot of my credit producing strategies, it still has many of the same characteristics that I would expect to find in the bullish put vertical spread. In this case, I have a bullish trade so it isn't surprising to see that my delta is now more positive than before.

Vertical spread portfolio impact

In addition, this trade is a mildly positive theta trade so it will benefit from the passage of time. Actually, the more ITM this trade gets, the more positive the theta will become. If the underlying IWM drops below my short strike too much, this will turn into a negative theta trade. That's an important factor to keep in mind.

At this point, my expectation is bullish on IWM. All I need to do on this long vertical spread is let time pass and have IWM continue to push upward.

Update 5/6/2010 (closing update)

This long vertical spread trade been on that long and the loss limit order already triggered, caused largely by the major selling that has taken place. The thing with this order is that while my stop loss was $.63, it actually triggered a market order, which filled at $.57. That means I lost a little more than I'd planned. As with all trades, there is a risk that the worst case scenario could occur. That's why I size my position with the worst case scenario in mind.

With this trade, I bought 6 contracts for $1.27 and sold them back for $.57, which means I lost $.70 per contract or $420. That's slightly more than my planned loss, but not too much more. The trade is about 100% loss against my projected profit and about a 2% of my portfolio. I don't like it when I lose money on a trade, but I like it a lot better when I know the loss is capped.

vertical spread exit analysis

I want to wrap up this trade page with some thoughts on my execution of this trade. One of my exit plans was to consider exiting if I saw a strong close below $72.50. With the recent wild market action, there might have been a couple of opportunities to exit. In particular, last Friday might have been a chance to exit but then Monday had a strong bounce. Of course Tuesday reversed that bounce and I probably should have exited early in the day yesterday instead of waiting for a close and then executing the order today. As I mentioned before, I always have a plan in place to limit my loss but had I been a little more vigilant, I might have been able to get out with a very small loss.

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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