Important Announcement

Trade of the Week - Vertical Spread (7/30/2009)

I put this put vertical spread trade on the morning of  7/30/2009 for a credit of $.51. I am selling the DIA August 90/88 put spread.

Put vertical spread on the DIA

DIA Aug Put Vertical Spread 90/88
1. Exit if I can lock in 80% of my initial credit ($.10)
2. Exit if it costs me more than $1.02 to exit

3. Exit 4-7 days before expiration

This is $2 wide spread, which would be the maximum loss this trade could sustain, but I took in $.51, so my total risk in the trade is only $1.49.

Why this strategy?

There are two different aspects to this trade that caused me to consider a bullish position. First, I'm showing part of a fibonacci retracement on the chart and the DIA today broke above the 38.2% level in addition to also breaking through the resistance that was established over the past few days. Second, I'm also considering my other positions, which are currently fairly bearish. Without getting into too much detail right now, here is my current combined SPY weighted delta for all my open positions.

Put vertical spread analysis

Prior to putting this position on, I had a negative delta of -50.56. That means I really would like the underlying ETFs for the positions I'm holding (the SPY & DIA) to go down. The other motivation for putting on a bullish trade is to add some positive delta to make my overall delta less negative.

This opens up a whole conversation on position management that I won't go into here, but plan to discuss on another page. Let me summarize it this way... I have several positions that are being run over and will only be hurt by a continued move up. By putting on a bullish position, I lessen the potential loss I could face if my positions get run over. On the other hand, if the market does pull back, I've paid a small price (call it insurance) for this protection.

Choosing the right strike prices

As per my trading plan for short vertical spreads, I'd like to choose a strike price with a delta .35-.40 (or probability of expiring at around 30%). This one was  a choice between over over 30% or under 25%. The $90 short strike was my selection at just over 30% - a little higher than usual, but acceptable under the circumstances.

Position sizing

I already know going into the trade what I stand to lose ($1.49 - or $149/contract). On a $20,000 account, I will risk just 1% on this trade or $200. Given the current environment and the fact that I'm already hedging off some risk of a trade with 2 contracts, I don't want to make matters worse by adding too much risk. With $200 total risk, I'll just take 1 contract.

Note on position sizing: As a rule, it is best to maintain a consistent % risk for every trade, however there are times when it is appropriate to scale back the position size.

Exit plan

My exit plan is to exit when one of several things occur.

  1. I can lock in around 80% of the credit - meaning I close for around $.10 debit
  2. Exit if it costs me more than 2 times my initial credit (or $1.01) to close. That will help minimize the sustained loss in this trade
  3. I'm within 4-7 days of expiration

This is a slightly different type of trade. It is a vertical spread traded with the usual trading rules but put on with other existing trades in mind. I'll continue to monitor this trade to see how it plays out and post weekly updates as usual.

Update 8/6/2009

It's a good thing I have a bullish position on. I currently have two bearish positions that are just plain getting run over so its nice to have one that is actually doing well. I could close this vertical spread position for around $.28, which is a $.23 profit to date.

The one thing I didn't do when I put the trade on was put on a 'good til cancel' order in to close the trade. With busy schedules, it is a good idea to put my exit plan into a fixed order when possible.

I put this order in this morning as a GTC. If DIA continues to move up, then this trade will probably close before too long.

Update 8/13/2009

Well, it's a good thing I have at least one bullish trade on. I originally put this vertical spread on to offset some of the risk remaining in my call spread from the iron condor I put on way back at the beginning of July. The puts were closed leaving the calls remaining. Those are currently run over. I chose to put this spread on to offset some of that risk an it has paid off.

I originally put the trade on for $.51 and right now could close the trade for around $.14. I have a limit order in place at the moment to close when I can do so for a debit of $.10, so I'm pretty close. If not this week, certainly by Monday unless we see a healthy pullback. That likelihood is looking pretty slim.

I'm guessing the next update will be regarding the close of this trade as my other exit rule will be to close within 4-7 days of expiration. That will be Monday or Tuesday at the latest.

Update (Trade close) 8/14/2009

Well, that was fast! Yesterday, I said we were close and with the move up in the DIA combined with a drop in the volatility, this vertical spread shed a few more pennies to bring it right into my standing order to buy back at $.10.

That means this trade locked in $.41 of gain, which is an actual ROI of 27.5%. Remember, my actual risk in the trade was only $1.49 so I'd calculate the ROI as .41/1.49 = 27.5%.

This was pretty much another textbook trade. I put it on thinking there was a chance DIA would continue to move higher and it pretty much did without any surprises. I want to take a moment to consider this trade in combination with another trade I had on... the SPY iron condor from back in early July. Remember, the put spread had closed leaving me with a short call spread and a lot of negative delta.

How do I figure this trade in with the iron condor? Let's break it down into pieces. I originally put on 2 contracts with a credit of $1.09 per contract or a total net credit of $218. That left a risk of $.91 per contract or $182. Later in the month, I closed the put side by paying $.20/contract or a total of $40. That makes my total risk $222. With this vertical spread  trade, I locked in $41 in credit on the one  contract. So, if I combine the remaining risk on the iron condor trade with the credit of this trade, I'm back to around $182 in risk. I've essentially paid for the cost of closing out the put spread.

In the best possible scenario, SPY sells off hard for the next few days and I actually get to close that remaining call vertical spread for something close to $.20 debit. However, I'm not counting on it. If that trade finishes a loser, I'll learn from it and move on.

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.

[?] Subscribe To This Site

follow us in feedly
Add to My Yahoo!