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Trade Tutorial - Put Vertical Spread (12/2/2010)

Given the recent bullishness, I'm going to enter a new put short vertical spread..

Short vertical spread on the DIA

Sell IWM 59/57 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. $.88)
3. Exit if within 4-7 days of expiration
Credit $.44

As I said in the newsletter earlier this week, I was going to wait for a clear break of the congestion area over $1200. Two days later it happened...

Why this strategy?

We are starting to see some of the worry over the US economy and European finances dissipate. As I had mentioned in the newsletter, the market could have either broken through support or rally from the lows. Since we now have a clear break of the $1200 level, I'm ready to be bullish again.

As I also have mentioned in the last few 'Options Strategy Focus' articles, the process of selecting a strategy needs to take into consideration not only market bias but also timeframe and fault tolerance.

The strategy I had in mind this morning as I was setting up the trade is a short put vertical spread. The reason is that this is a reasonably short term (2-4 weeks) trade and can allow some degree of movement against me without ultimately being a loser.

Why the DIA? Because I have a position already on SPY and EWZ. I considered the IWM but ultimately the DIA seems like a better setup. I'll explain this more later.

Choosing the right strike prices

With the short vertical spread, my rules for strike selection is to look for a short strike having a probability of expiring (ITM) of between 30-35%. I also want an option that has at least 20 days until expiration. December options only have 15 days left in the expiration cycle.

Short vertical spread strike selection

In this case, we're talking about the January $110 put. When I first started researching this trade, the $110 had a probability of expiring of 37%. However the initial rally this morning resulted in this being right at the perfect point.

As I usually do, I look for a long strike $2 below the short strike as hedge position. That way the most I have at risk is $2. The nice thing about this trade is that the short strike at $110 is also right at a support level where the last bounce occurred.

Risk/Reward analysis

This trade results in a credit of $.44. With a $2 wide spread, that's a risk on my part of $1.56 (assuming I enter the trade and just let it go). With a $.44 reward and a $1.56 risk, that's a reward risk of 28%.

As I usually do with my vertical spread trades (at least for this year), I use a stop loss order to limit my loss in the trade to an amount equal to the initial credit. By doing this my risk in trade drops to $.44 per contract. With this exit, I also employ an early exit rule to lock in 80% of the initial credit. In that case, my reward is $.35 With these new rules, my reward/risk ratio is 79%.

Position sizing

With early exit rule, my risk in the trade is only $44 per contract. This is a starting point. With my portfolio currently at $16,264 and a portfolio risk tolerance of 2%, I can risk just $325. As a result, I can sell just 7 contracts and remain within my risk tolerance.

With 7 contracts, my actual risk will be $308 and my target gain will be $245.

Exit plan

I have talked about my exit rules to limit loss and to lock in profit. I have one more absolute rule that I follow. That is to exit when the trade is within 4-5 days of expiration. I've explained the rationale for this in past trades. Briefly, the gamma risk that is introduced in the last few days before expiration makes this a high risk trade.

To summarize, I will exit under the following conditions.

  1. I will exit when it costs $ 88 to close. This will limit my loss in the trade to just $.44 or $308 total.
  2. I will exit when I can do so for $.09. This will allow me to lock in a profit of $.33 per contract or $231.
  3. I will exit when approximately 4-5 days of expiration

As I often point out at this point, the best way to ensure that the first two rules are enforced consistently, I employ the use of a one cancels other (OCO) order. This one of the nice features of the thinkorswim by TD Ameritrade platform. If your brokerage doesn't support this kind of order (or stop losses on spreads), consider switching to thinkorswim.

Portfolio Impact

My portfolio is already somewhat bullish. Since my goal is to become more bullish, it isn't a surprise that this put vertical spread adds additional positive delta (along with positive theta).

vertical spread portfolio impact

I want to point out a couple of things here. First, the EWZ position is still on even though officially I'm out of that trade. That means my portfolio delta is actually only about 110 and my portfolio theta is more like 10.8.


Update 12/31/2010 (closing update)

I closed this trade today, the last trading day of the year. I'd characterize this last week between Christmas and New Years as "reluctantly bullish". As a result, it's worked out pretty good for this trade.

Let's quickly run down this vertical spread trade and see how it turned out. I entered the trade for a credit of $.44. My order triggered closing me out for a debit of $.09. That leaves a net profit of $.33. Since I sold 7 contracts, the total profit in the trade is $231. Since my share of the margin in the trade was $1.56 (or $1092), my return on investment (ROI) is 21%. Since I had a plan to limit loss to $.44, my return on risk is 75%. These are pretty great numbers overall.

As I've mentioned before, it's a little more difficult to draw lessons from successful trades. However, I've said a few different ways that following my rules will pay off over the long term. If nothing else, think of it this way. A successful trade like this  is the reward for consistently following the rules.

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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