Entering the August Credit Spread Trade

by Jay Pestrichelli on July 26th, 2012

It’s that time again to discuss entering the monthly out-of-the-money credit trade.  Despite the recent volatility, we’re going to keep our bullish outlook, but be sure to leave plenty of room for error. As readers of this blog may recall, this trade is designed to be profitable if the market moves higher or lower by only a marginal rate.

The vehicle we’ll use again are options on the NASDAQ 100 index, NDX. Of course this data will change as the market trades, but as of yesterday’s close, we would have looked at creating a credit put spread with the following strikes:
  • Short NDX AUG 2300
  • Long NDX AUG 2350
  • Net credit of $2.10 (4.4%)
  • Probability of success 96.8% (3.2% risk)

Thanks to the recent volatility we’re able to create a spread that has a return of 4.4% with a risk of 3.2%. This is the kind of ratio we look for. The way this trade pays off is when the credit value goes to zero and you keep the premium that the spread was sold for. At expiration, that means that the NDX closes above 2300. With the NDX currently at 2550, that means 250 points away from the current mark or 9.8% to the downside.

As always, the most important part of this trade is knowing when to exit if the market moves against us. Our rule of thumb is to close out the position if the spread value doubles. In this case that is if the spread value rises to $4.20.

Keeping a watchful eye on this position is important, so this is one of those rare reasons why we’d encourage investors to check quotes daily. We’ll update this trade throughout the month, so come back for more direction as the trade progresses.

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