Trade Tutorial - Put Vertical Spread (11/18/2010)

I'm entering another short vertical spread, which I often refer to as a credit spread. This trade is a bullish position, which means I'm selling a put spread.

put vertical spread on SPY

Trade
Sell SPY 117/115 put spread
ROI
30%
Exits
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. $.94)
3. Exit if within 4-7 days of expiration
Credit $.47

This is going to be a run-of-the-mill vertical spread but makes a nice compliment to the diagonal spreads I have on.

Why this strategy?

In the last newsletter strategy focus column, I discussed strategy selection. Factors I'm considering in this trade include duration, bullishness, objectives of the position, etc. This is a relatively short term trade who's objective is to generate income and add bullish deltas to the portfolio.

Also in the last newsletter, I mentioned that I was going to use any pull-backs as opportunities to enter new bullish positions. I currently have two bullish positions on, which are diagonal spreads. These are debit positions and have taken a fairly large chunk of my risk capital. The nice thing about the short vertical spread is that it is a credit position and ties up a relatively small amount in margin.

Choosing the right strike prices

As always with the short vertical spread, I start by finding the short strike to sell, which must have at least 20 trading days left in it. In addition, I look for this strike price to have a probability of expiring of 30-35%. This means the trade has an approximate probability of success of 65-70%.

How did I come up with that number? If you're new to these tutorials - or if you aren't familiar with the term 'probability of expiring', let me explain. On the thinkorswim by TD Ameritrade platform, one of the statistics related to an option is it's probability of exiring ITM by $.01 or more. The probability has a lot to do with current volatility, time until expiration and other factors. Logically then if the probability of expiring (ITM by at least $.01) is 30-35%, then the probability of the option expiring worthless is 65-70%. In this kind of position, that would be a successful trade.

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vertical spread strike selection

In looking at the option chain for SPY, I obviously have to look at December since this is expiration week for the November options. I'm looking at the $117 put as the short strike. Notice that the probability of expiring is slightly above my 35% acceptable range. The reason I'm targeting this strike is because as the market opens this morning, I'm noticing an unusual buying sentiment following several days of selling. By the time I got the trade entered, this value had dropped below 35%. In addition, $117 is right at the current 50 day moving average, which I'm expecting to act as a level of support on pullbacks. With the current up trend, that moving average will continue to rise as well.

Since I typically take $2 wide spreads for these trades, my logical choice for the long strike then is the $115. The credit I am receiving for this trade is $.47.

Risk/Reward analysis

Since this is a $2 wide spread, it carries $2 per contract of risk minus the credit. That means my risk in the trade is $1.53. In this case my return on risk is 30%. That's a decent enough trade if the odds of success were high enough. This is after all a 65% probability trade.

Is there another way to improve the probability and the return on risk? Probably not both. As I've mentioned before you can't improve your probability without giving up profitability.

That said, the strategy I use in the short vertical spread is to limit the risk in the trade to an amount equal to the credit I received. However, my other exit strategy includes closing the trade to lock in 80% of the initial credit. That means I'm risking $.47 to make about $.37. That's obviously a better return on risk and equates to about a 78% return.

Position sizing

I've already covered my planned risk in the trade, which is equal to the amount of the initial credit. My portfolio currently is at $15,544 (due largely to the two diagonal spread purchases). In each trade, I risk just 2% of the portfolio, which would be $310. With a risk of $.47, that means I can sell just 6 contracts. That means my target profit in this position is $.37 * 6 * 100 = $222.

Exit plan

I've already covered most of my plans for exit in this trade. I have an exit plan to limit loss to just $282. I have an exit plan to lock in profit of $222. The only exit rule I haven't covered is the one to close prior to the actual options expiration. As I've mentioned on several occasions, I don't tend to hold positions all the way to expiration. The risk is too great in the last week major price changes due to the increase in gamma of the options.

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

  1. I will exit when it costs $.94 to close - I want to limit my loss on the trade to $.47 per contract or $282 total.
  2. I will exit when I can do so for $.10 - this will lock in a little less than 80% or about $222
  3. I will exit when approximately 4-5 days of expiration

Portfolio Impact

This is a bullish position, which is my objective in this case. Since I'm bullish I would expect to be adding positive delta to the position.

vertical spread porfolio analysis

As the above capture shows, the delta is higher as expected. However notice that the theta is rather small. This is due the fairly large negative theta of the EWZ position. This is due to the fact that this is only a long position. I expect to sell another short call on this soon, which will restore the theta back to a larger positive value.

 

Update 12/6/2010 (closing update)

The trade closed exactly as planned. This was helped of course by the resumption of a bullish trend.

This trade was a pretty straightforward. As planned, I exited the position for a $.10 debit. This trade was entered for a credit of $.47. That means I've realized a net profit of $.37. I sold 6 contracts, which means a net profit of $222.

There's not much that can be said in a trade that went as expected. While the bounce behaved as expected, it could have easily gone the other way. In that case, I would have experienced my maximum loss. However, I contend that the keys to success in a trade are found in some very basic concepts.

  1. Good technical analysis to determine trend for desired timeframe
  2. Selection of a strategy that matches that trend and timeframe
  3. Having and following clear rules for entry, exit and money management

When I look back on the trades that have lost money, many of them were due to not following the rules in one way or another.

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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