I mentioned in a post at the end of last week that I planned to get back into IWM today. I almost decided not to since the small-cap ETF continued to climb and appeared ready to correct. Then I opted to change my approach and allow room for a correction or a continued small rally. To do that, I had to sell put spreads in the money. While IWM was trading at $92.17, I sold three IWM March $94 puts for $2.27 each and bought three IWM March $91 puts for $.87 each. I received $415.38 after paying $4.62 in commission.
This helps build on my small allocation for contracts expiring in March. The only other positions I have for March expiration are a DIA put spread that’s still in the money and a SPY naked put that’s out of the money by 2%. I still have a lot more cash on the sideline that has to be put to work and the more I look at my choices, the more I think I will need to use put spreads in the near-term.
I thought about selling naked puts on this before switching plans, but the downside risk was bigger than this trade’s risk and the upside potential was smaller. Once I realized that, the decision was easy. I don’t want to make the same mistake I’ve done in the past and lose money on naked puts when I should’ve hedged or stayed in cash. The only negative is that I need IWM to gain some more ground before I take a full profit versus having a little buffer with the naked put. I don’t think IWM will be within 2% of today’s price by the middle of March, so this should serve me better in either direction.
I also chose March for this put spread to expire because it was priced within a penny or two of the April contracts, but had less than half the time value. That means my annualized return is better with the shorter duration contracts. In addition, I know we’re going to get a correction eventually. However, I don’t know if it is a day away, four weeks away or three months away. I increase my probability of a profit by running this trade on a shorter time horizon in this case due to the extended duration of this run without a step backward. In other words, every additional week the market moves higher without a step backward increases the probability of a correction coming sooner and likely with a decline that’s bigger.
IWM Risk/Reward Breakdown:
- Potential profit: $462.62
- Money at risk: $484.62
- Potential put spread return: 85.71%, 95.2% per month
- Upside potential based on cash reserves: 1.49%%, Annualized: 19.93%
- Downside cushion: no cushion, need a gain of 0.48% to break even at $92.62
- Downside risk based on value of underlying if assigned: 1.74%
- Timing remaining before expiration: 3.9 weeks
- Position close goal/limit: I’m aiming for full profit. I’ll let it play out until the final week before the contracts expire. I’ll probably take the assignment and sell my long puts for a profit if I think the downside is limited from there. If small caps look vulnerable to further weakness, I’ll close the full position within the final couple of days of the contract.