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Trade of the Week - Long Call Vertical Spread (10/16/2009)

Although this long vertical spread trade isn't one I've talked about on any of my strategy pages, I'm choosing to trade it anyway. This is a long call vertical spread, also known as a debit spread.

Call Vertical Spread Entry

Buy EWZ 74/76 call spread
1. Exit if I can lock in 60% return on my investment (about $1.70)
2. Exit if value of spread drops to 1/2 the initial debit  (about.$.55)
3. Exit if within 4-7 days of expiration
Debit $1.06

As usual, I am trading a $2 spread on an ETF. If you are wondering why I always trade ETFs, check here.

Why this strategy?

This particular trade is the rough equivalent of a short put vertical spread in a couple of ways. First, it is a bullish trade as is a short put spread. Second, the P&L graph looks pretty much the same. 

debit spread analysis

There are also a number of key differences in this kind of trade as compared to a credit spread.

  1. While not necessarily a requirement of a debit spread, I tend to put these on a little more in the money
  2. As a result, my expectation for the movement of the underlying is different - I expect EWX to make a more bullish move
  3. My trade rules are different in that I tend to view these similarly to any of my trades that are put on for a debit. My max gain/max loss rules are different
  4. Psychologically speaking, I tend to view debit trades differently than credit oriented trades even though they aren't fundamentally different.

Choosing the right strike prices

Typically, a debit spread is put on with the long  strike in the money and the short strike out of the money. That isn't a requirement. I could easily make both strikes in the money, in which case it would more resemble the characteristics of a short put vertical.

As I mentioned, I chose my long strike to be one strike in the money at $74 and my short strike to be one strike out of the money at $76 with the current price running right around $75. I chose this position because I think it is certainly reasonable to expect EWZ to move up above $76 if this current bullishness continues.

Position sizing

There are several ways I could determine my position size for this spread trade. Since this is a debit spread, I could simply divide the cost of each contract into my risk amount per trade (which has been 2% of my portfolio or about $400). That would equate to 3 contracts.

Another way to position size could be based on an amount I am willing to allow this trade to lose before closing early. For example, let's say I'm willing to allow this trade to lose approximately 50% of the initial debit. I'll allow it to go just over that 50% and close if it loses $.55 (from an initial target price of $1.08). In that case, the same percentage risk would allow me to buy 7 contracts. However, I MUST close this trade as planned or I stand to lose more than 2% of my portfolio.

On the Thinkorswim platform, I can enter my initial order as a limit order to ensure I get filled at a desirable price. While the range between mid price and the natural ask is slightly wide, I'm going with the mid price and in fact got filled at $1.06 debit.

Call Vertical Srpead order entry

Exit plan

I will exit under the following conditions.

  1. I will exit when it I can sell the spread for a 60% gain - or $1.75
  2. I will exit if the trade loses approximately 50% of its initial value (about $.55). For simplicity, I'll set the closing price at $.50
  3. I will exit when approximately 4-5 days of expiration if neither of the above two events occur

As usual, I've found the easiest way to ensure I follow my exit plan is to have the order already in. On the Thinkorswim platform, I can set a One-Cancels-Other (OCO) order such that either one or the other order will trigger, whichever comes first.

Vertical Spread exits

Just to summarize, this is a long vertical spread trade, which is also known as a debit spread. It is bullish so that means it is a call spread. If you've followed any of my other trades of the week, you'll quickly recognize some differences between other vertical spreads I've put on for a credit. You may also see some similarities to trades I've put on for a debit lit calendar spreads.

I mentioned pearler that psychologically speaking, I tend to view these trades differently. I don't know for sure if this is a good thing or a bad thing. It's simply something I've become aware of and am watching in myself. The value of a trade journal (which this page is representative of) and the trade log (which can be found here) is that over the long term, I can determine which trades and which trading plan(s) work best.

Portfolio Impact

One of the things I want to begin to consider in these trade of the week pages is the impact of the trade I'm entering to the overall portfolio. I've begun to talk about this more in other trades. The key things I'm interested in are my portfolio delta (weighted to the SPY), my theta and my vega. 

vertical spread portfolio analysis

In this case, the impact of this trade is rather telling in terms of ways the long vertical spread is different from short vertical spreads. The most significant impact I found is that it adds slightly negative theta to my portfolio. Why is this? As long as my short strike is out of the money, this will be the case. As EWZ pushes higher, my long call will gain in value while the short call will lose value in its time premium component. 

The other thing that is significant is that my delta has become more positive as a result of this trade. This vertical spread adds quite a lot more positive delta making my portfolio skew towards the bullish side. If I was going to consider another trade, I might be looking for a trade that adds negative delta, positive theta and positive vega.

Update 10/23/2009

A week into this vertical spread trade, EWZ has been 'there and back again" at least once. By that, I mean a few days after I put the trade on, EWZ rocketed past 76 and was well on its way. However, there were a few days early this week when EWZ sold off heavily.

I've noticed a few interesting things regarding EWZ versus the market. There were a few times this week when the market was selling off but EWZ was gaining in value - even if only by a little. There is obviously some strength in the emerging markets and may be where folks are moving money when the US markets are looking soft.

I say all of that to point out that a lot can happen in any trade, but even with all the movement back and forth, this trade has made money. Why? Because like many spreads, the short strike loses more value than the long strike over a given period of time. Obviously if EWZ went completely against me, I'd be experiencing a loss but even if it went nowhere from here until expiration, I'd make some money. That's the power of spreads.

Update 10/28/2009

With the general weakness in the market, I got jiggled out of EWZ with the stop order I had in. Is that a bad thing? No. I put this long vertical spread on knowing that it was in tension with other bearish trades. It was a risk I took knowing that I was balancing this trade off against my other bearish positions.

debit spread exit

While EWZ has been showing relative strength of late, it has been particularly hard hit in the last week or so. Where does that leave this trade?

I put the trade on for a debit of $1.06 and closed the trade for $.50 credit, which leaves me with a loss of $.56. That's about a 52% loss on my initial investment.. I lost about $280 on the trade, which is just over 1% of my portfolio. Can I live with that? Yup.

The other thing to ask is... 'was this a bad trade?' I don't think so. I put the trade on with the best information I had in front of me. I put it on knowing that I already had bearish trades and I wanted to make sure that if the bullish trend continued, I'd make money in that direction. 

Here's why I consider this a successful trade. 

  1. I put the trade on with the best information I had
  2. I sized my position so that I limited my loss (using a stop loss as an early exit)
  3. I allowed my stop to trigger and I don't look back

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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