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Trade of the Week - Put Vertical Spread (10/29/2009)

I'm putting on another vertical spread trade this week. The recent strong pullback has made this a pretty good opportunity (assuming there won't be more selling).

vertical spread - SPY

Sell SPY 103/101 put spread
1. Exit if I can lock in 80% of my initial credit (i.e. $.09)
2. Exit if cost to close >= twice initial credit (i.e. $.90)
3. Exit if SPY drops below the recent low at $104
4. Exit if within 4-7 days of expiration
Credit $.45

As usual, this is a $2 wide short put vertical spread. I'm cutting this a little close in the sense that there are just over 20 days left in the current (front) option month.

Why this strategy?

I'm putting a vertical spread on at this time because there is a high likelihood that this recent pullback and the subsequent bounce could (emphasis on could) indicate a resumption of the upward trend.

I am somewhat cautious because we are heading into the end of the year when the market could in fact be a little stagnant and may even continue selling. However, all I can do is trade what I see. In this case, I see a pullback to the area of the 50 day moving average and a bounce.

I'm going to trade this one a little bit differently in that I'm placing a little more emphasis on technical analysis as an exit trigger. In this case, I believe that any move below yesterday's low (about $104) would signal that the selling isn't over and therefore the premise under which I put the trade on is wrong.

Choosing the right strike prices

As is my habit, I tend to trade ETFs and in this case, I like to trade the SPY as a proxy for the broader market. As I mentioned earlier, I am selling this vertical spread in the current options month, which only has just over 20 days left. That's cutting it close and does affect the price I get for the spread.

vertical spread entry analysis

I also like to sell the short strike with a probability of success between 65 and 70% (probability of expiring between 30 and 35%). That's a little aggressive but I manage this with stop loss. Once I have that position, which in this case is the $103 strike, I'll look to buy the $101 to form the $2 wide spread I like to trade.

When I put the trade on, this spread was selling for $.45 credit, which means I have a remaining risk of $1.55 if I let this trade run no matter what.

Position sizing

There are always a few different ways to manage a trade once it's put on. I could simply put the trade on and let it run its course, planning to close maybe 4-5 days prior to expiration. In this case, I MUST position size for the max loss of $1.55.

Another strategy that I often employ is to close the trade if the cost to buy it back reaches twice the initial credit. That means I stand to lose as much as I could have made (approximately). In this case twice the initial credit would be $.90 and I stand to lose $.45 of that. I may give a little more room for this trade to go against me by setting the exit price at $.95, which means my risk is $.50.

Next, I look at how much I can risk on this trade as a percentage of my portfolio. Using $20,000 as the basis, I allow 2%, which means $400 on this position. So, That means I could take about 8 contracts ($50 x 8 = $400).

vertical spread trade entry

If this vertical spread turns out as expected, it will result in a pretty nice return on my portfolio. As usual, I won't let this trade go all the way to expiration. I'll close when I can lock in 80%, which means I stand to keep $.36.

The other thing to consider is that even though I have a plan to exit before experiencing the maximum loss, my broker will still hold the entire $2 (times the number of contracts). That means I need to be prepared to have $1600 in margin held. For me, that's not a big issue since I don't have that many trades going but it is always a consideration when sizing the position.

Exit plan

As usual, I like to have several exits planned out for my vertical spread trade. I want to define at least one exit if the trade goes as expected and at least one exit if the trade goes against me. For my vertical spread trades I've been using the 20%/100% rule a lot. That means exit when I can do so for 20% of the initial credit (locking in 80%) or exit if the trade looses 100% of the initial credit (debit = twice the initial credit).

In this trade, I've also identified that I am absolutely wrong on my assumption that the upward trend has resumed if SPY falls back below the most recent low of around $104. 

With the first two rules, it's pretty easy to set up an order to manage this. This technical exit is a little more difficult (but not impossible).

vertical spread closing order

I could have added a third component to this OCO order that was a trigger to close if SPY reaches $104 (or some other price). I think for this trade, I'll simply monitor the trade and make that determination on the fly.

So, just to summarize, I will exit under the following conditions.

  1. I will exit when I can do so for $.09 - That will allow me to lock in 80% of the initial credit.
  2. I will exit when it costs $95 to close - I want to limit my loss on the trade to $400 (worst case).
  3. I will exit on a technical break of the $104 area - this is an indication that I am wrong on my assessment.
  4. I will exit when approximately 4-5 days of expiration.

Update 10/30/2009

I think that's the shortest trade I've ever put on. The vertical spread was on for one day and then I was out - and not in a good way either. My exit rule #3 above is what triggered my exit.

Here's what happened. Yesterday, I put the trade on when it appeared that SPY would be bouncing. At the end of the day, it actually looked like a genius trade.

vertical spread SPY exit trigger

Then things changed. As I mentioned in my entry notes, there was a risk that the selling wasn't finished, but all I could do was trade what I saw. The nice thing about this kind of thing is there is a clear line in the sand to draw from a technical perspective. Since the low of two days ago formed the pivot on which the up turn may have developed, it was a logical point to establish as support. 

The up shot was that I closed the position shortly after SPY broke 104. I managed to buy the trade back in for $.64. Since I received $.45 for this spread when I sold it, I lost $.19 on the trade or 12% on the trade (against my max risk of $1.55) and just .7% on the portfolio.

I hate being wrong about a trade, but I also hate missing out on a potentially good trade. The only way to manage risk is through having a good trading plan, exit strategies and good money management.

Update 11/15/2009 (Post trade analysis)

I feel compelled to review this vertical spread trade several weeks after it has been closed. The reason is that the recent market action is such that one might be tempted to second guess the decision to exit.

Let me play this out as the conversation goes in my head.

Hmm. I closed this trade but now the market seems to be resuming the uptrend. Maybe I was wrong to get out when I did. Maybe I my technical target rule to exit on break of support was a mistake.... Maybe next time, I'll just let the trade ride...

Does this sound familiar? Anyone who has followed their rules (which are designed to protect from significant loss) only to find the trade ultimately go in their direction has probably had similar doubts.

As I step back from this situation, let me ask a different question. Which of us in looking at the chart above showing the break of support would say with any certainty that it would reverse within the next day or so? Who would decide to put on the same short put vertical spread with the chart looking like it did?

The truth is that none of us have any sure knowledge of whether this was the start of another steep sell off or just a short blip. I'm certainly not willing to bet my portfolio on it. I've made that mistake before and I won't do it again!

In the midst of a this kind of internal conflict, what can I do? One choice is to simply hang tight and keep following the rules. Don't second guess them, especially over one instance. Another alternative is to change the way I size my position. Remember, this trade was sized according to the plan that I would exit early. In other words I'd limit my loss to an amount equal to the credit I received. I could have sized my position based on the maximum loss amount. In that case, I could be justified in staying in even if the trade went against me.

Had I done so, I would probably still be in the trade and while my trade ROI would have been pretty decent, my return as a percentage of the portfolio would have been fairly small - yet would have been positive.

It's worthwhile from time to time to step back and ask yourselves these kind of questions. I've learned that the internal battle in the mind is the hardest part of learning to trade successfully.

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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