Important Announcement

Trade of the Week - Put Vertical Spread (11/05/2009)

I'm putting on a vertical spread in addition to the iron condor I put on yesterday. I'm doing two trades this week since I was down to just one position after closing so many positions last week..

EWZ vertical spread chart 

Sell EWZ 57/55 put spread (8 contracts)
Sell EWZ 80/78 call spread (4 contracts) on 11/16
1. Exit if I can lock in 80% of my initial credit (i.e. $.10)
2. Exit if cost to close >= twice initial credit (i.e. $1.02)
3. Exit if within 4-7 days of expiration
Credit $.51

As usual, I'm doing a $2 wide spread and I'm putting it on for a $51 credit. That leaves a remaining risk of $1.49.

Why this strategy?

Yes, it's another vertical spread on the EWZ. But hey, look at the chart. EWZ is still in a bullish trend and the vertical spread has worked pretty consistently for me. I am not wildly bullish. If I were, I might consider something a little more aggressive. 

The short vertical spread has been a good strategy and as I've said in the past, 'It's my bread and butter strategy'. I usually try to have at least one of these on at any given time.

Choosing the right strike prices

When setting up a vertical spread trade, I'm unusually looking to find a short strike that has a probability of expiring between 30 an 35%, which means there is a probability of 65-70% that this strike will expire worthless.

vertical spread strike selection

I'm starting to look for trades in December since there are only about 13 days left in the November option cycle. 

I haven't mentioned some of my other criteria for options lately because with the ETFs I trade, they are kind of a given. I want to make sure that the open interest is high enough (really the higher the better). With only 8 or so contracts, I'd like to see open interest greater than several hundred. In this case the number is more like 10,000. That helps me get a better fill price and not run the risk of moving the price of the option by my trade.

Position sizing

I want to start by talking about my trade risk for this short vertical spread. There are several ways to calculate this. My absolute risk is calculated by subtracting my credit ($.50) from the the spread ($2) , leaving a risk of $1.50. However, that is only true if this trade remains on permanently.

I've been adopting a strategy whereby my risk is limited to an amount equal to my credit. That means if I put this vertical spread on for $.50 credit and set one of my exits to stop out if it cost $1.00 to buy the trade back, then I am only risking $.50 of my own money in the trade.

My standard portfolio risk amount is 2%, which currently equates to about $400 of risk per trade. That means I can take about 8 contracts and still stay within the $400 trade risk.

Here's deal though. My broker doesn't know or care that I have a stop in place to exit early. Therefore, they will hold the entire $2 spread in margin, which will be $1600. I need to make sure I have enough in my account and am willing to tie up that much on this trade

vertical spread entry

When I actually put the trade on, I got filled at $.51 (slightly better than planned). 

Exit plan

Lately, I've been incorporating some technical exits along with my typical mechanical exits. I intend to trade the trend but I need to be nimble enough to recognize changes in trend. As a result, I will be watching EWZ relative to the diagonal trend line. I would say a fall below this trend like would be cause for concern and may be worth exiting.

In addition, I want to make sure I exit if the cost to close this vertical spread reaches $1.00, which is my 2X rule for exiting. I also want to exit if I can lock in 80% of the credit. I'm not willing to hold this trade all the way to expiration if I don't need to. So, I'll close the trade when I can buy it back for about $.10, leaving me a profit of $.41.

Just to summarize, I will exit under the following conditions.

  1. I will exit when it costs $1.02 to close - I want to limit my loss on the trade to $.51, which is an amount equal to my credit.
  2. I will exit when I can do so for $.10 - This allows me to lock in 80% of the credit
  3. I will be watching EWZ relative to the trend line for any breaks that would indicate the bullish move is ending
  4. I will exit when approximately 4-5 days of expiration
vertical spread exits

As I've mentioned before, I prefer to execute my first two rules using an OCO order on the platform. That way, I don't have to spend all day monitoring for one of these rules to trigger me personally to take action.

Portfolio impact

I've recently been adding a portfolio impact section to the trade setup. I've begun to realize that it's important to be aware of how my portfolio as a whole looks as a result of the trade. In fact, I typically start by looking at my portfolio before putting the trade on.

vertical spread portfolio impact

As this picture shows, the EWZ vertical spread added a fair amount of positive delta to the position. This offsets the negative delta coming from the SPY iron condor and the DIA calendar spread. The other thing I like to see is that my theta is positive, which means I'm benefiting from the passage of time.

Update 11/12/2009

Over the last week, EWZ has generally moved up pretty nicely. At one point, the price of EWZ was $10 more than the short strike. That said, I'm still not at a point where my exit has triggered yet.

Since this vertical spread uses December options, the lion's share of the time erosion won't start happening for another few weeks. In the mean time, I'll continue to monitor the trade. I'm also considering the possibility of putting on some form of short call vertical as well to make this an iron condor. I may put on a $1 wide spread so that my bias is still to the up side. 

I go through this exercise on every trade, not because I plan to take action, but because I want to be prepared to take action and having ideas established ahead of time makes it a lot easier.

Update 11/16/2009

I went ahead and put on a trade similar to what I talked about last time. Instead of selling a $1 wide spread though, I sold half as many contracts of a $2 wide spread. I did this because I take less of a hit on commission by selling 1/2 as many contracts but twice as wide of a spread. However, the resulting trade is the same.

This turns the initial put vertical spread into a skewed iron condor. This changes the characteristics of the trade quite a lot.

Vertical spread adjustment

What this adjustment does is add some amount of upside risk but lowers the downside risk. I put the initial trade on for $.51 with 8 contracts. I put on the short call vertical for $.54 but sold only 4 contracts. To make this an equivalent analysis, let's divide $.54 in half and treat it as if it were 8 contracts. That would be $.27 making the total credit about $.78 leaving a down side risk of $1.13 and an up side risk of $.12.

This adjustment doesn't change my exit rules for the put spread. I will leave my stop in place for the put vertical spread (exiting when the cost to close is $1.02). The effect of this is that if that stop triggers, I only lose about $200 (assuming I keep the call spread intact)

In terms of any exits on the call spread, I won't be putting on any stop or limit orders initially. If the market does sell off and forces me to exit the put spread, I'll leave this one on - maybe all the way until expiration. I'll continue to evaluate this position as time goes on.

Update 11/27/2009

With the market (and EWZ) beginning to flounder a bit, this trade is working out OK. I'm still waiting for an opportunity to close the put spread AND at the same time, I'm monitoring the call spread to see if there's an opportunity to close that.

Since I've turned this vertical spread into a sort of skewed iron condor, I'm a lot more neutral in terms of what I want to happen. Right now, if EWZ went nowhere, it would make money as I get closer to expiration.

For now, all that can be done is to continue to monitor the trade. I've lowered my up side risk to $200 and I just need to make sure that on a pullback, my rules take me out before a large loss occurs.

Update 12/1/2009

Ok, so the put side of this trade finally closed for a $.10 debit. That leaves me with a small call vertical spread with about $200 total risk.

Actually, that's not quite accurate. When I put the adjustment on, I calculated that the equivalent up side risk was about $.12 (times 8 contracts). That would be about $98 in total risk. However, I just paid $.10 to close the put spread so my equivalent up side risk is now $.22, which makes the total risk $176.

As it stands, EWZ is pushing my short call strike and is trading at year highs. There is a possibility that it could break out over these highs and start a new run.

Update 12/14/2009

As of Friday's close, EWZ is back below my short 78 strike. Remember, I had put on a call vertical spread with 1/2 the number of contracts as the original put spread.

We are now in expiration week so things could get interesting. I'll be looking to close this position in the next day or so.

One other item to mention is that I also put on an adjustment trade over a week ago, partly in response to the potential that my calls could be over run. This was put vertical spread (or credit spread). This is a pretty small position at two contracts. If EWZ continues to move up, the credit spread will become profitable and will help offset any loss I may experience on this trade.

Update 12/17/2009 (closing update)

I was able to close the calls this morning for $.09 when the market pretty much started the day down and headed further down.

Let's take a look at how this trade turned out. I put on 8 contracts initially for $.51 and closed them for $.10 leaving a net gain of .$.41. I put on 4 contracts of a call spread for a credit of $.54 and closed them today for $.09 debit leaving a net gain of $.45. In order to compare apples to apples, I'll divide .45 by 2, which is $.225 for a total net gain on this trade of $.635.

My initial risk on the trade was $1.49 but with the additional $.27 in credit, the risk was reduced to $1.22. This was the absolute risk I would experience and also the amount of my own money that was held in margin to be in this trade. So, my ROI then is .635/1.22 or 52%.

This was a nice trade and especially welcome since several of my other positions haven't done so well.

With this pullback, I'll be looking for other opportunities to take a bullish entry... unless there is an indication of a bias shift to a more neutral or bearish trend.

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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