Important Announcement

Trade of the Week - Put Vertical Spread (11/23/2009)

I'm putting on another put vertical spread. While it's unclear if the market will continue with a strong push up, I think another put spread here is appropriate.

put vertical spread setup

Sell IWM 58/56 put spread
1. Exit if I can lock in 80% of my initial credit (i.e. $.08)
2. Exit if cost to close >= twice initial credit (i.e. $.80)
3. Exit if within 4-7 days of expiration
Credit $.40

I put this spread trade on a little differently than I ordinarily do. Since I couldn't sit around and monitor the order, I simply put on a limit order, which got filled mid day. As a result, the screen captures will be more historical than real time.

Why this strategy?

I hesitated all last week in putting on a trade. I did this first, because it was expiration week and crazy things happen during expiration week. I also hesitated because I wasn't seeing a clear direction that I could trade against.

I had determined that a bounce was imminent and was waiting for a signal that the near term trend had reversed. Yesterday morning looked like it was just what I was waiting for so I placed my vertical spread order.

I like vertical spreads when the market moves in a defined direction (besides sideways). This spread can do really well in a trending market and shows a lot of resilience even when the market doesn't move anywhere.

Choosing the right strike prices

As usual for vertical spread trades, I'm looking for a short strike with a probability of expiring between 30% and 35%. This will give me a trade with a probability of success of around 65% - 70%, which is right in my sweet spot.

December options are still a good choice for a few more weeks since there is still enough time value left in them.  As I usually do, I selected the long strike such that I end up with a $2 wide spread. That leaves me with a $58/56 put spread.

Since I took in a credit of $.40, my remaining risk in the trade is $1.60 if I hold the trade to expiration.

Position sizing

As I usually do, I am calculating my trade risk based on an exit rule I follow for vertical spread trades. I will close the trade when the cost to close is twice the initial credit. That makes my actual risk in the trade equal to my potential reward. 

In this case, the credit is $.40 so I'll close for $.80 making my risk in the trade $.40.

I calculate the amount I'll risk total by first determining my trade risk as a percentage of the portfolio. Since I'm willing to risk 2% on any of my trades, that equates $400. With $.40 (or $40 per contract) risk, that means I could take 10 contracts.

I actually made a mistake in my calculations and only sold 8 contracts. The thing to keep in mind is that my broker will hold $1600 in margin, assuming that I could face a maximum loss. I need to be able to have that much margin held in order to place this trade. Since I took in $320 in credit, only $1280 of that is my own money.

Exit plan

My exit rules for a vertical spread are pretty well established and easy to implement. I usually have a target 'best case' price and a a 'worst case' price on which I'll close the trade.

In this case, my exit rules are as follows.

  1. I will exit when it costs $.80 to close - this is my 2x rule to limit my loss
  2. I will exit when I can do so for $.08 - this is my 80% rule where I want to close when I can lock in 80% of the initial credit
  3. I will exit when approximately 4-5 days of expiration - I don't like to hold trades in the last week of expiration

As I regularly mention, I allow the platform to help me ensure that I follow my first two exit rules. On my platform, I can set a 'one cancels other' or OCO order to enforce both exits. In my case, this order would look like this.

vertical spread exit orders

Notice that one order is a limit order to close when the price is at or below $.08 while the other is a stop order to trigger when the mark is $.80 or higher.

Portfolio Impact

I've been also indicating the impact to my overall portfolio for each trade. It is important to understand how the trade fits in the overall portfolio mix.

vertical spread portfolio analysis

The two key things to notice right off are my weighted delta, which is negative and my overall theta, which represents the theoretical amount of money I make each day even if the market goes nowhere.

My negative delta value means I will stand to benefit more by a move down in the SPY (and general market). The IWM trade I just added lowered this significantly, which adjusts my portfolio to be a little less bearishly biased than it was before.

The positive theta value means that my overall portfolio is largely premium selling strategies (no surprise). However, note that the SPY position has a negative theta. That's because right now, it is so overrun that it is actually is gaining in value (or cost to close price) as time moves on. I'll address this in my trade summary for that position this week.

Update 11/27/2009 (trade close)

Well, it happened again! I put on a trade and the stop popped me out shortly after being in it. This market is pretty tough!

vertical spread trade failure

Friday morning, the market gapped down at the open just enough to trigger my exit. In fact, this illustrates one of the dangers that could exist in this kind of situation. My initial exit price was for $.80. However, with the gap down, the order filled at $.87. That means I lost a little more in the trade than I had initially planned. Since I received $.40 in credit to open the trade, my loss amount per contract is $.47 times 8 contracts or $376. As it turns out, my miscalculation in sizing the position turned out in my favor since I still remained within my 2% per trade loss limit.

While I was tempted to re-enter the trade, the wise thing to do is let some time go by and not be motivated by the desire to revenge trade. Monday, I'll re-evaluate the market and determine whether another opportunity exists to enter.


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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