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Trade Tutorial - Put Calendar Spread (1/22/2013)

I'm entering a calendar spread, which might seem to be a bit counter-intuitive. This trade has been a bit long in coming since I had mentioned in the last newsletter that I would be entering a trade soon.

Calendar spread chart analysis

Buy SPY Feb/March 146 put spread
1. Roll/Close if I can lock in 30% ROI or more (i.e. $1.50 or so)
2. Exit if within 4-7 days of expiration
Debit $1.15

At the beginning of January, I had anticipated entering a more bullish to neutral position. You might be wondering why a put calendar spread makes sense with the strong bullish market.

Why this strategy?

If you look at the chart above, you can see that there has been an extended bullish push. In addition, the VIX has dropped to lows not seen since 2007. The result is that there is hardly any premium value in selling vertical spreads.

The question is, with an extended move away from the 30 day moving average and low volatility, what strategy would take advantage of a minor correction? We need a strategy with a bearish nature that would benefit from an increase of volatility. One such strategy is a calendar spread. Specifically, a put calendar spread a few strikes below the current position would make sense.

This strategy takes a little bit longer to play out than a vertical spread so that means my market outlook needs to be for a little longer. This calendar spread has about 3-4 weeks left in it before I exit.

Choosing the right strike prices

Now that we know we want a put calendar spread, the next question is what strikes to select. The decision of what strikes only has a few conditions. First, I want to make sure the short strike has at least 20 days until expiration. Second, I want to select a strike price that isn't too far away from the current price but in the area of where I expect the SPY to fall in the next few weeks.

Calendar spread strike selection

I've selected the February $146 put as the short strike as I'm expecting the SPY to fall to around the $146 level. Since I'm only interested in a fairly short period, I'll go with a 1 month spread. As we see here, the debit for this trade is $1.15.

Risk/Reward analysis

Calendar spreads are interesting in that calculating max profit is not an exact science. Instead, we'll use a couple of different techniques. The first is to use the analysis tool on the thinkorswim platform to calculate potential maximum profit at expiration. What this shows is that one contract of the SPY $146 Feb/March calendar spread MAY be worth $100 more than it cost ($115), which means nearly a 100% potential return.

Calendar spread reward/risk analysis

However, this is only possible IF I hold the spread all the way to expiration and IF the SPY happens to expire exactly at $146. The chances of these two events is pretty slim. Notice though that the range of profit is fairly wide. This calendar spread will show a profit if in the range of $143.24 to $148.62 at expiration. Assuming there is a selloff into this area, the chances are good this calendar spread will turn a profit.

Let's consider another way to analyze this trade. That is using the option chain itself. On the thinkorswim platform, there is a way to play a little 'what if' game. So, we can say, 'what if the SPY were to drop $2 in the timeframe of about 1 week prior to expiration?' The answer is shown below.

Calendar spread reward/risk analysis

In order to get there, we need to perform a couple of steps on the trade tab.

  1. Change the Spread type to Calendar. Because there is a Feb quarterly option between the regular February and March options, I had to select 'deep and wide' -> 2 month 1 strike -> Calendar to get the right spread combination.
  2. Adjust the date to Feb 8, which is about 1 week before expiration
  3. Adjust the price down $2 to simulate the SPY selling off by $2 (down to $147 or so)
  4. We can see that the theoretical price in this case is about $1.50

This represents a less than ideal scenario but is fairly reasonable. To complete the analysis, the theoretical gain would be about $.35 (1.50 - 1.15). That is about a 30% reward/risk ratio. This also represents the return on risk. We'll use that as the project ROI for this trade.

Position sizing

As many who follow these tutorials know, I have a specific position sizing rule. This is no different for a calendar spread. I will risk no more than 2% of my portfolio in any one trade. In this case, I know my risk per contract is $115 (the debit paid to enter). My portfolio is currently  $17,377, which means I can risk $347 on this trade. That means I can buy 3 contracts of this spread and remain within that risk threshold.

Exit plan

For a one month calendar spread, there aren't too many exit rules that I employ. The main one will be to look for an opportunity to lock in my projected gain of $.35 or better. However, this won't be an absolute limit order. What I'll do is monitor the position to see if I can get at least that much or more.

That said, I will still have an absolute exit rule to close the position in the last week of the short option's expiration cycle.

So, my exit rules are as follows:

  1. I will roll (or close) the position if I can lock in at least a $.35 (30%) gain.
  2. I will exit when approximately 4-5 days of expiration

Portfolio Impact

I put this trade on as a bit of a counter trend trade. The idea is to profit from an anticipated sell-off. As a result, it should be no surprise that the resulting delta of this position is negative. Notice, however that this is still a positive theta trade - as are most of my trades I promote.

Calendar spread portfolio impact

The key thing about the calendar spread strategy though is that it is one of the few that has positive vega. That means if the volatility increases (as is likely in a sell-off), then I benefit in three ways.

  1. From the passage of time (theta)
  2. From the SPY going in my direction - closer to the short strike
  3. Volatility increasing

The combination of these three can make this a really profitable trade.

Update 2/21/2013

Ok - the short put expired last Friday (actually, Saturday at noon). That leaves us with a long put that is currently a ways out of the money. For a while it was looking like this trade might be a total loss until... the market started selling off finally.

With the pullback selling off all the way to the 30 day moving average, what are my choices? It depends on what I believe will happen next. In order for the long put to be worth much at all, it will need to sell off even more. This has the look of wanting to find support at the moving average so my expectation is that we'll see more bullishness now that we've had the selling.

What can I do with my existing long position that can make this a bullish trade? What if I sold a put somewhere above the long put but below the support at the moving average? The problem is that I already have the risk amount in the original trade, which was $1.15 per contract and my position was sized accordingly. How can I create a bullish put vertical spread without adding more risk to the trade?

It turns out that if I sell a short $147 put, which creates a $1 wide spread I can do so for a $1.17 credit. What that means is that in the worst case scenario I would actually be trimming $.17 off the original cost of the trade and in the best case scenario, I would actually make $.02 on the trade as a whole.

Let's examine this a little closer. I bought the original calendar spread for $1.15. The short put expired worthless leaving me with a full $1.15 potential risk (per contract). I sold a $147 put for $1.17 creating a $1 wide spread. That means if the options expire with the SPY fully ITM, I would lose $1 of that trade. So, $1.15 debit + $1.17 credit - $1 loss = net loss of $.98.

If the options expire with the options fully OTM, then I get to keep the credit. So, $1.15 debit + $1.17 credit = net gain of $.02.

This trade seems like a win/win. In the worst case,  I've decreased my potential loss in the original calendar spread trade. In the best case, I actually make a little money - but only if I let the options expire completely worthless.

Note: I put this trade in yesterday about an hour before the closing bell. Today, I have a GTC order to close the spread for a debit of $.05.

Update 3/5/2013 (Closing Update)

This update is a little (well a lot) late in getting out but I wanted to finish the narrative on what happened with this trade. The good news is that the market continued as expected and the trade closed at the target exit price.

So, here's what happened. Due to the strong rally in the early part of March, the put spread quickly decreased in value allowing me to close for better than my target price. I had a limit order to close at $.05 but with the gap up in the market, I was able to close for $.03. Let me recap how this adjustment worked and how the trade as a whole turned out.

My original trade was bearish as I had expected a market selloff that never appeared. When it began looking like the market was more bullish than expected, I began looking for an adjustment that would allow me to minimize my loss - or even profit from the change in direction.

I bought the original calendar spread for $1.15 but the short put expired worthless. I then sold the $147 put for $1.17 to create a $1 wide short put vertical spread. I then closed the spread for a debit of $.03. That means the trade as a whole had a net loss of $.01. Since this was originally a 3 contract trade, that means a total loss of $3.

That's not too bad for a trade where I was completely wrong on my original assessment. I've mentioned before that I'm not a huge fan of adjusting simply for the sake of adjusting. However, there is a time and a place for it. It was clear from the overall market outlook that I was wrong in my original trade. The adjustment changed the trade from a bearish one to a bullish one, which was consistent with my new outlook. The bonus was that if the adjustment turned out to be a losing trade as well, I would have minimized the loss of the original and if the trade turned out as expected, I would have broken even on the trade.

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

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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