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Trade of the Week - Put Vertical Spread (7/9/2009)

This is the perfect trade for busy schedules. I put this vertical spread trade on in the first hour of trading on Wednesday, 7/9/2009.  I was able to sell this spread for $.60.

Put Vertical Spread

XLU Aug Put Vertical Spread 27/25
1. Exit if I can lock in 80% of my initial credit (i.e. $.12)
2. Exit if cost to close >= twice initial credit (i.e. $1.20)
3. Exit if XLU closes below 7/8 low of $26.72

The nice thing about this trade is that it has a $2 wide spread, which would be the maximum loss this trade could sustain, but I took in $.60, so my total risk in the trade is only $1.40.

Why this strategy?

While the rest of the market and many ETFs have broken the trend and are forming lower highs and lower lows, XLU remains in an up trend. I chose to put on a fairly tight put vertical spread with the understanding that any break of the trend or a cost to close of twice my initial credit I'll be out.

Choosing the right strike prices

Choosing a the short strike was a little more difficult on this trade. Ordinarily I like to chose a strike price a few strikes out of the money.  As I've discussed on the vertical spread strategy page, I usually prefer a probability of expiring (worthless) of 30-40%.  In this case, there is no $24 strike price so it's not possible to go one strike price down.

Put vertical spread trade entry

This is a slightly riskier trade, however as we'll see soon, I manage that a number of ways.

Position sizing

The worst case scenario on this trade is that I could potentially lose $143/contract.  However, one of my exit strategies is to close the trade when it costs twice my initial credit to close. That means my risk in the trade is actually only $60/contract. On a $20,000 account, I will risk just 2% on this trade or $400. Therefore, I can take 400/60, or 6 contracts. The key to using this approach is that I must be ruthless about exiting when I say I will.

Exit plan

My exit plan is to exit when one of several things occur.

  1. I can lock in around 80% of the credit - meaning I close for around $.12 debit
  2. If I stand to lose more than I took in as a credit ($.60)
  3. As a backup technical exit, I will exit if XLU closes below yesterday's lows or around $26.72

The key to following my exit plan is to have an order in place that will ensure that one or the other of the first two strategies gets executed. I can do this by entering a "one cancels other" order.

Put vertical spread - one cancels other order

As I'm illustrating here, I can set up an order where one or the other gets filled and the remaining order is canceled. In order for this to work, I need a stop order to execute when the price reaches my max threshold.  Note: in this illustration, I had $1.15 entered when the price should be $1.20. The other order is a plain old limit order to exit when I can buy back the spread for $.12.

The nice thing about this type of trade is that it is very low maintenance so it can work well for folks who have busy schedules or work during most of the trading day.  In a trade like this, I put the order in first thing in the morning and set up my exits as well.  Now, it's just a matter of waiting for one or the other of my exits to trigger.  At the end of the day, I can review the trade and if I see the price fall below my technical level, I can simply do a market order close first thing in the morning.

Update 7/16/2009

Since putting the trade on this trade, this ETF has pretty much gone up - after a few days of stalling and even slipping below the short strike of $27.

Put vertical spread - trade of the week

As I've highlighted here, XLU did establish a  lower low although it appears to be remaining in a upward channel. The next question is whether a higher or at least equal high will be established. To do this will mean breaking the current resistance level at $28. However, with the number of strong up days, it wouldn't surprise me to see a pause or even small pull back before resuming.

This vertical spread has already made half the credit in time decay (i.e. I could close the trade for $.30).

Update 7/23/2009

A week later and we've really seen XLU contiue to move up.

Here the XLU is shown moving decisively above the $28.50 area I'd outlined last week. And with that, I think this trade is about ready to close. In fact, I checked today after the market closed and it appears that the mark (mid price) is below my bid price to close the spread. What's up with that?

The deal is that the bid/ask spread is fairly wide on this vertical spread and likely it will require me paying a few pennies above the mid price. This happens sometimes. While it's nice to get filled at the mid price, it doen't happen that often for me except on the SPY or DIA. Let's see what a few more days bring. There's still three more weeks until expiration and more time value that can decay.

Update 7/24/2009

Sure enough, this order filled first thing this morning. In fact I got filled at $.10 debit, a tribute to trading in a paper money account. This probably wouldn't have happened in a real account unless there was a considerable gap up. Since I just posted an update yesterday, I won't put up a final chart as the one above tells the story.  This was an ideal trade. It went as planned and really required very little maintenance. 

Here are the final status. I entered for $.60 credit but paid $.12 to close (I'm going with that because I likely would have filled at $.12, not $.10 in a real account). That leaves a net credit of $.48 on a total risk of $1.20. That makes my ROI 40% in just over two week's time.

And that concludes this trade... another successful one. For more information on vertical spreads, be sure to check out the overview page on this strategy.

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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