Trade of the Week - Put Vertical Spread (8/19/2009)

You can't fight the trend, so I'm putting on a bullish vertical spread.  Even though I've continued to expect a pullback of some size (3-5%), it simply hasn't materialized. I currently have a bearish calendar spread and a neutral iron condor on. This will balance things out a little by adding a bullish trade.

This time, I'm putting on another put spread on EWZ. This is an ETF I've traded before and it remains in a fairly bullish trend.

EWZ Sept Put Vertical 54/52
 Expected ROI
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. $.90)
3. Consider exiting if EWZ closes below 8/17 low of $56.80

This is my usual $2 wide spread so I have a max gain of $.45 and a max loss of $1.55. That's about a 70% probability of success trade.

Why this strategy?

This the vertical spread is what I call my "bread and butter" strategy. It works in a lot of different environments and when I want a bullish or bearish position, this is one of the first ones I think of. I picked this strategy on this stock because EWZ appears to be bouncing off the 30 day moving average. That's one of my favorite entry points as I mention in on the vertical spread strategy, the technical analysis, and moving average pages.

With the recent pullback, volatility has jumped up a little bit, which gives me a little better premium.

Choosing the right strike prices

One of the techniques I often employ when selecting the short strike for a vertical spread is to pick a strike with a probability of expiring ITM at around 25-30%. That translates into a 70-75% probability that this short strike will expire worthless, which is the same as saying my probability of success is 70-75%.

This morning when I put the trade on, that short strike was the $54 put. At the time, the probability of expiring was around 28%.

As always, I try to make sure the open interest on any strike price I choose is high enough to support the number of contracts I'm trading. I prefer if my trade represents less than 1-2% of the overall open interest. One way I do this is by picking highly liquid ETFs like EWZ.

As usual for my vertical spreads, I trade a $2 wide spread, so with $54 being my short strike, my long strike for this position will be $52.

As a final check, I like to make sure that on a $2 wide spread I can get at least $.40 of credit or it isn't really worth the risk.

Position sizing

There are two ways I could determine my position size for this vertical spread. I could go by the maximum loss amount, and size the position around that, or I could go by my exit strategy and size around a projected loss if my exit is hit.

In the case of plan A - the max loss situation, I stand to lose $155 for each contract I sell. I need to follow a consistent risk amount, which in my case is 2% of my portfolio. Right now, that is 2% of $20,000, which is $400. With $400 to risk and $155/contract of risk, I can sell only 2 contracts.

In the case of plan B - I am willing to risk about the same as my credit. Meaning that if my exit is to close when the cost to close is twice the initial credit, then I would be risking just $45/contract in the trade. Using the same $400 of risk, I can take 8 contracts. However, what happens if I should fail to follow my exit rule? I have 8 contracts and for some reason, the stock gaps down in a huge way causing me to face a maximum loss. That would be 8 x $155 = $1240. Yikes!!

If I'm going to trade this strategy consistently, then I should follow the same rules each time I trade. That means picking one of the above sizing approaches and staying with it. In the past, I've sized my vertical spread based on the 2x exit (with one exception) This means my loss will roughly equal to my initial credit (in this  case, $.45). So in this case, I'll go with the 8 contracts BUT that means I must also put in my mechanical stop loss to ensure that I don't allow my emotions to keep me in the trade when I should be getting out. 

Exit plan

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

  1. If I can capture 80% of the initial credit. In this case I'll exit if I can do so for a debit of $.09.
  2. If it cost me twice my initial credit to get out, then I'll close the position. Actually, I'll use 105% just to give me a little margin. That will be $.92.
  3. In this case, I took the trade due to an expected technical bounce off the 30 day moving average. The low point on this bounce was around $56.80 so I should consider a technical exit if EWZ closes below that level.

How can I make sure that these rules are followed? On the thinkorswim platform, it is actually pretty easy. For the first two rules, I can set up a 'one cancels the other' order (OCO). It would look something like this.

The key to putting both orders in at the same time is the change the Advanced Order selection to 'OCO'. Then, I can have one limit order to close for $.09 and a stop order to close for $.92. Which ever order fills, the other will automatically cancel.

On the last rule, I can use the platform to set up an alert to sent me a text message if there is a break below that level. The alerts are under the 'Market Watch' tab in the 'Alerts' section.

Update 8/26/2009

A week into this trade, we have seen 1/2 the time premium of this vertical spread melt away. As of today's close, there is still about $.23 left in the spread. My target to close is $.09 so I can close this trade if another $.14 melts away or EWZ resumes its move up. This early in the game, there's not really much to do. The first week or so is pretty hard if you tend toward impatience as not much goes on. It looks like EWZ may want to come down and test the 30 day MA before resuming the move up. If this happens while time passes, I could easily see this trade closing next week.

If it looks like this move up is beginning to stall - or even reverse, one thing I could do is put some call vertical spreads on making it a somewhat unbalanced iron condor. This can add more positive theta to the position without adding any additional margin requirements. I would likely not want to put on as many contracts on the upper side simply because I don't want to add additional risk simply to pick up more credit or hedge some downside risk. Remember, to hedge risk in one direction means shifting it to the other side to some degree.

Update 9/4/2009

Well, I waited too long to put on a call vertical spread. The last week has resulted in EWZ pulling back - in fact breaking through the 30 day moving average. I does look like it found support at the 50 day moving average.

In the midst of this move down and now the small bounce, this position has continued to erode away time value. As of this morning, I'm down to $.15 to exit, just $.06 left. This could happen just over this long Labor day weekend. This is exactly why I prefer these premium selling strategies. A lot of nothing can happen and yet the trade still makes money.

Thinking defensively, what will be be plan if EWZ reverses? At this point, I'll plan to exit this position if EWZ reverses and closes below the 50 day MA. To me, this would be an indicator that the trend is reversing, particularly as the lower high would be established and would be heading for a lower low. This might also be another opportunity to sell some call spreads, however we're running out of time for this option period.

Update 9/8/2009

Well, it didn't take long. The closing order for this vertical spread trade finally filled late this afternoon at a closing price of $.09.

EWZ continued to move up like clockwork. I initially received a credit of $.45 for the spread and closed for $.09, leaving a net profit of $.36. That was a $.36 profit on a risk of $1.55, which is a realized ROI of 23.2%. My total profit in this trade is $.36 x 100 x 8 contracts = $288.

This turned out to be a really nice bullish trade. This illustrates the importantce of trading the trend. I've continually believed there was going to be a pullback (and still do). However, it's obvious it isn't coming immediately. To hold out and not trade what I'm observing in the trend would mean missing out on the profit of this trade. This has been one of the hardest lessons for me to learn.

I'm sure glad I had some bullish and neutral trades on this time!

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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