Trade Tutorial - Call Vertical Spread (12/10/2010)

Here's another vertical spread (or credit spread) trade. This time it's a bearish position that's designed to provide a little balance to the portfolio and to my existing put spread position.

vertical spread on DIA

Sell DIA 118/116 call spread
1. Exit if I can lock in 80% of my initial credit (i.e. $.05)
2. Exit if cost to close >= twice initial credit (i.e. $1.15)
3. Exit if within 4-7 days of expiration
Credit $.55

Why enter a bearish trade now? Let's take a look at the rationale I'm using for this trade.

Why this strategy?

After another round of buying at the beginning of the month we're beginning to see some consolidation. Now, this could just be preparation to pushing up to newer highs. That's something I'll need to be watching for.

That said, it's also possible that heading into the end of the year and beginning of January the market could consolidate for a longer period or even begin an extended selling period. I'm starting to see indications of weakness as it seems like good news in the market has been met with selling. This sometimes can be an indicator that a turn is about to take place.

In considering my various strategy choices I considered the short call vertical spread and the put calendar spread. The reason I went with the vertical spread was because it's a little bit shorter term trade and I'm not yet convinced we'll see selling as much as weakness for the next few weeks. The other reason is that I currently have the put spread on the DIA and it seemed like an opportunity to balance this trade out, turning it into a sort of iron condor position.

The thing to watch out for is that this consolidation could result in additional buying into the end of the year. As a result, I'll be employing a technical exit along with my other exit rules.

Choosing the right strike prices

My entry rules for strike selection for the short vertical spread call for a short strike having at least 20 days until expiration and a probability of expiring (ITM) of between 30 and 35%. Since December options expire next Friday I'm looking at January options. The best fit is the $116 short call.

vertical spread strike selection

Since I routinely enter $2 wide spreads, the long strike then will be a January $118 call. The entire spread can be entered for a credit of $.55 leaving an absolute risk in the trade of $1.45.

The result of this position is that I'll have a spread that is about 200 DOW points away on the call side and 400 DOW points away on the put side for a total spread of 600 DOW points or $6 on the DIA.

Risk/Reward analysis

I've already established that the credit on this trade is $.55, which represents the maximum gain or max reward in the trade. The risk is $1.45 if I let the trade go completely ITM into expiration. With these absolute values the reward/risk ratio would be 38%. This is also the return on risk for the position.

That's not a bad return for a vertical spread but as most know from following past trades, I rarely let a trade go fully to expiration. My typical exit rules are to close the trade if I can lock in 80% of the initial or if the cost to close the trade is twice the initial credit. In this case, that means my target gain would be $.44 and my risk would be $.55. This reward/risk would be 80%, which is pretty decent.

As I've mentioned on several trade tutorial pages, the increased reward/risk or ROI doesn't come without trade-offs. Any time I attempt to increase my return or reduce risk I trade off something. In this case, there is a higher probability that the trade could be a losing trade - meaning I could lose all or part of the $.55 I am risking.

The reason for this is that this trade is designed to trigger an exit earlier than if I just let the trade fully play out. That means I automatically remove the possibility of benefiting from the underlying turning around and resuming the trend for which I entered.

Let me put it another way. When I was selecting the short strike, I selected one that had a probability of expiring ITM by a penny or more of around 31%. That means I have a 69% probability that the short strike would expire worthless. However that assumes I hold the trade until expiration and it takes into consideration the entire range of movement of the underlying based on the volatility at the moment.

Taking an action that causes me to exit earlier to limit loss also disregards the probability that the trade could still work out. Therefore, I would be exiting earlier and locking in the associated loss more frequently with this strategy. Since I've been using this strategy for over a year in these tutorials and talking about changing, this will probably be the last vertical spread trade I do using the early exit to limit loss.

Position sizing

Position sizing is a critical part of any trade strategy. My standard rule is to risk only 2% of my portfolio in any given trade. I will not change this going into the new year. My current portfolio value is at $16,661, which means I can risk $333.

Using my exit rule of closing when the cost to close is twice the initial credit, this trade has a risk of $55 per contract, which means I can only sell 6 contracts (barely). 

Exit plan

In addition to my standard exit rules, I will be also using a technical exit. The reason is that my initial analysis and reason for entering the trade was due to an expectation that the DIA will exhibit weakness over the next few weeks. As a result, if the DIA were to break above $114.75 with some increased volume, I'd Consider my analysis incorrect. In that case I'll exit the trade taking whatever loss there is.

I will exit under the following conditions.

  1. I will exit if the DIA closes above $114.75 on above average volume
  2. I will exit when it costs $1.10 to close - This will limit my risk to $.55 or a total of $330
  3. I will exit when I can do so for $.11 - This will lock in 80% of my initial credit for a total target gain of $264
  4. I will exit when approximately 4-5 days of expiration
vertical spread trade management

As always, I employ a OCO order to ensure that my two standard exit rules are enforced. It's a little harder to do this with a technical exit. In the case of limiting my loss with a stop loss order, this is something that not every options broker supports. If your broker isn't thinkorswim from TD Ameritrade, then make sure you check with them before attempting this kind of strategy.

Portfolio Impact

This vertical spread is a bearish trade. My expectation is that it will reduce my overall positive delta while adding additional theta. Adjusting delta and adding theta are often the objectives of any trade I enter.

As we see, adding the short call vertical spread has caused my combined DIA position to have an overall delta of  -11.6. In addition note that I still have a fair amount of positive delta from the phantom EWZ position (visit this trade tutorial for more detail). Not counting that position, I have an approximate position delta of 19.24. Overall, that's only a slightly bullish bias to the portfolio, which is what I'm expecting.

Notice also that the theta is higher but is being dragged down by the long EWZ call. Not counting that negative theta, my portfolio theta is about just over 6, which means it would experience approximately $6 gain per day just in time passing with the market going nowhere. 

Update 12/29/2010

If you by chance had placed this order (or other order on the DIA), you may have noticed something odd happened with your options. For the record, my recommendation is to always enter these trades as a paper money trade, not as a real money trade.

Here's the deal. The DIA issued a special dividend of $.25, which reduced the overall value of the DIA by $.25. To compensate, all the options strike prices had to be decreased by $.25. As a result, the vertical spread position in an actual cash account would now contain a position that is a $117.75/$115.75 call spread.

So far, the paper money account hasn't been adjusted and possibly won't be. However, if such an even does occur, any open orders will be cancelled. Make sure you get limit and stop orders placed again if they were cancelled.


Update 1/3/2011 (Closing Update)

The strong open this morning forced me out of this trade. I had mentioned in the most recent newsletter that there was a small possibility that we could see a move above the overhead resistance.

Unfortunately that's exactly what happened. It will take a few more days to a week before it becomes clear whether this stop triggered a premature exit. Be that as it may, I'm out of the trade making this the first losing trade of the year.

Let's see how this trade worked out. I entered the trade for a credit of $.55. The stop loss triggered me out out for a debit of $.97. Because the order triggered at the market open likely what happened was that when the stop order converted to a market order, it was filled at a slightly lower price. As a result, the actual loss in this trade was only $.42. Since I sold 6 contracts, that means the trade lost $252.

Should I have exited this trade earlier? In fact, I had a technical exit (that I forgot about) that indicated exiting if DIA closed above $114.75 on above average volume. On 12/16, there was a push above $114.75 (but not close) on above average volume. Several days later, the DIA pushed above $115 and stayed above that level. It would have been a good opportunity to either exit then or made a trade adjustment.

How could this oversight have been prevented? I neglected to add an alert that would have reminded me to take action. I could have been more disciplined to review my trades relative to my exit rules, which were well embedded farther up this page. The critical thing to remember when using exits that aren't enforced by any kind of automated exit is that some means must used to enforce these exits with the same rigor that would be used by a stop loss order. For me that is typically the alert I mentioned. This at least offers a reminder to go back and review 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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