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Trade of the Week - Put Vertical Spread (9/28/2009)

I am putting on another put vertical spread. After just a few days of selling, the market appears to have resumed its upward climb. This trade is a little bit unique in that it not only is a trade that stands on its own and but is one I chose to put on to meet the objectives of my overall portfolio.

Vertical Spread trade of the week

Sell IWM 59/57 put 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 $.40

This trade is a $2 wide put vertical spread on the IWM with a potential gain of $40/contract and a potential risk of $160/contract. That will produce a return of about 25%. That's not a stellar return for this kind of trade but decent considering the objectives for which I put it on.

Why this strategy?

I chose this trade for a number of reasons. First of all, I've been considering another bullish trade given the recent pullback we've been experiencing in the market overall. As crazy as it is, there are still buyers out there willing to drive the market up and I've got to trade what's there. Second, I did an an analysis of my existing portfolio and came to the conclusion, I need more positive delta. Here is the video I recorded on this.

In the video, I outlined an analysis using a put vertical spread on the SPY. Rather than put another position on there, I decided to go with the IWM, an ETF that follows the Russell 2000 index. One reason I chose the IWM is because it has shown a higher relative strength than the S&P 500. Since the sell off last year and the bottom established in March, the Russell 2000 has nearly regained 61% of its highest level while the S&P 500 has not even regained 50%.

Choosing the right strike prices

Once I've settled on the strategy and the instrument (the IWM), the next step is to determine what strike I will sell. One issue I'm running up against is there are now less than 20 days left in this option cycle so it will take a little more aggressive position to get a decent price. I usually like to sell a vertical spread with a short strike probability of expiring right around 30% (70% probability of success). However, this time, I went a little closer and chose a strike with a 34% probability of expiring, which is a 66% probability of success.

Vertical spread - picking strike prices

Selecting a $2 wide vertical spread will give me a credit of around $.40 with a risk of about $1.60.

Position sizing

A common theme I preach in the position sizing section is to make sure not to take too large of a position that will jeopardize my overall portfolio. As a rule, I risk about 2% of my portfolio, which right now is approximately $400.

There are two ways to calculate my risk. One is using the absolute risk amount I mentioned earlier, which is $1.60 or $160 per contract. However, I often set up an exit plan where I will exit when the cost to close is around twice my initial credit, which would be around $.80. That would make my risk in the trade only $.40 (If I pay $.80 to close the trade, the first $.40 is giving back the credit while the next $.40 comes out of my pocket).

Let's take a look at position sizing using these two approaches. 

Using the first approach, I would simply divide $400 by $160 to arrive at just over 2 contracts (but less than 3 so I'll round down).

Using the second approach, I'd divide $400 by $40 to arrive at exactly 10 contracts.

While selling 10 contracts sounds more attractive to my bottom line, I'm not sure I want to take that much risk... at least not in one position. My original objective was to balance out some of my negative delta while taking in some more premium and not taking on to much downside risk. Therefore, I'm going to sell just 2 contracts.

For the record, this is not my usual approach. I would typically go with closer to 10 contracts but this trade is interrelated with other trades.

Here is my trade entry.

Vertical spread - trade entry

Exit plan

When I trade vertical spreads I usually follow several exit rules that I rarely deviate from. I mentioned above that one of my loss limit exit plans is to close the trade when it costs twice the credit. In this case due to the position size and the rationale, I'm going to adjust the rules slightly.

  1. I will exit when it costs $1.15 to close - I want to limit my loss on the trade to $150 (in case you're wondering that price is $.40 + .75)
  2. I will exit when I can do so for $.05 - I want to give a little more profit room in the trade, especially if it makes a move to the up side
  3. I will exit when approximately 4-5 days of expiration

Rather than having to monitor my trades minute by minute, I can set this trade up as one-cancels-other (OCO) order and my first two exit rules are covered without me even needing to monitor the trade. Here's what that looks like.

Vertical Spread - exit plan

Overall impact on m y portfolio

This trade didn't have quite the effect to the delta as the trade I analyzed in the video. Part of this is because of the strong move up this morning. As the SPY continues to move up, my portfolio delta will continue to become more negative unless I do something to adjust it. However, my options are becoming limited for this month so anything I do now will probably need to be for November expiration.

Vertical spread - portfolio analysis

This vertical spread trade has been a little different from the usual trade, both in the motivation for putting it on and in the rules I've followed. It's important to have the structure of rules to follow and for the most part I don't deviate from them. When I do, I try to have a good reason and make sure that even then, I'm following a consistent set of rules.

Rule # 1 - Don't lose money.
Rule # 2 - Never forget Rule #1  (Warren Buffet)

Update 10/5/2009

Well, after putting this vertical spread trade on, there followed pretty much a week of selling. Here's where we're at on this position.

Vertical spread position

The interesting thing is that I initially ended up with a slight negative delta on the portfolio as a result of putting this vertical spread on. However, with the sell off, I am now positive overall. No big deal though.

Take a look at how IWM pulled back to the 50 day MA and bounced (apparently). This position was an adjustment trade so I'm not too interested in doing anything to adjust this position. I have exit rules in place with accompanying orders so there isn't much to do.

How does my overall portfolio look right now? I'm currently sitting at a positive 20 overall delta. Not too bad really. I am currently sitting at the lower end of my overall portfolio range of profit, although its a little difficult to calculate this given that I have a calendar spread and a diagonal spread, both of which extend beyond the current expiration.

That said, there isn't much to do except let the market play out.

Update 10/12/2009

This was a pretty short trade. I only put the position on two weeks ago and will be closing this week now matter what since it is expiration week.

I have an order to close for $.05 in place. Today, I could close for $.10. That's tempting but let me explain why I'm giving it another day..

I put this position on as an adjustment to my portfolio delta, which at the time was somewhat negative. Since then, the market has moved down (making my delta more positive) and back up again. The risk to my positions is still to the up side. If the market was to sell off today or tomorrow, the only risk I now have is this position, which is a very small percentage of my overall trade risk. So, while this trade would be at risk on a move down, the remainder of my positions would benefit.

I have decided to keep this position on and close it when I close the DIA call vertical spread, which is the remainder of an initial iron condor trade of the week. Since both trades have exit rules to close 4-7 days prior to expiration, I'll be closing tomorrow morning at the latest.

Update 10/14/2009 (closing trade)

As planned, I closed this trade Tuesday morning. I paid $.19 to get out, a little more than my original exit. However, since I received $.40 credit for the entering this vertical spread, I made $.21 in profit. 

This vertical spread was initially put on as an adjustment to the negative delta in my portfolio. As it turns out, it would have been better had I followed my usual rules for entering and position sizing for a vertical spread.

That said, this trade yielded a $.21 gain on a margin requirement of $1.60 making the ROI 13%. However, this was only on two contracts so my total dollar gain on this position was $42.

That's not too bad and the gains here more than offset the small loss on the iron condor trade. I'll be updating the option trading tutorials page with the results of this and the iron condor trade in the next day or so.l

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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