Trade of the Week - Put Calendar Spread (2/3/2010)

This trade is a 1 month calendar spread on DIA but it actually could have 2 rolls if you count the potential roll to the March quarterly options.

Calendar spread on DIA

Buy DIA Apr/March 100 put spread
est 40%
1. Exit if I can lock in a 40% return of my initial debit
2. Roll/exit 4-7 days prior to exit
3. Consider an exit if DIA closes above 30 day MA on strength
Debit $.80

This trade adds a little more bearish bias to my portfolio but I'm ok with that. The price was good and there are actually two rolls since there are March quarterly options.

Why this strategy?

I mentioned in the February newsletter that I'm switching my bias somewhat from bullish to bearish or neutral. I'll remain this way unless I see more bullish indications, such as DIA closing above the 30 day moving average on above normal volume.

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I chose this strategy for several reasons. The last few days have been a bounce from last week's sell-off. I'm not completely convinced that's all the selling there is and I expect that there may be some more selling or chopping around. With volatility dropping a little bit, I start thinking about calendar spreads. Remember that a calendar spread benefits from a rise in volatility. Put calendars also benefit from the selling that often provokes the rise in volatility.

I like calendar spreads because they are pretty fault tolerant and often make money even if I'm wrong.

Choosing the right strike prices

Strike selection with a calendar spread is a little more complicated than for vertical spreads or iron condors. The actual strike selected should initially be in the area where the underlying is expected to be in the target time frame. My trading plan suggests selecting a short strike several strikes below the current price and 20-40 days remaining until expiration. At this point, February doesn't have too many days left and this makes the initial cost of the spread too expensive.

Calendar spread strike selection

In the trade setup above, I've highlighted the $100 strike, which is about 3 strikes below the current price and currently has about a 37% probability of being at or below $100. This position for an April/March spread is only $.80. That's pretty cheap for a calendar on the DIA at this strike price.

There are several ways to analyze the position to determine potential return. One is using the trade page itself (if you are using the Thinkorswim platform). What we would like to do is determine what a reasonable value might be under certain circumstances. By changing the spread type pull down to 'Calendar' and setting one of the columns to be 'Theo Price'. I can set this up.

Calendar spread trade analysis

What I've done in the above screen capture is expand the Feb/March option chain, move the date ahead to the Friday before the February expiration and adjust the potential price down $2, which would put it at roughly $100.63.  This says that a $100 calendar spread with the short strike only having a week until expiration and being near the target strike price should have an estimated value of $1.35.

Since I only need to pay $.80 for the calendar spread, I might stand to make $.55 if I was right in my price estimate within the last week before expiration. That's a 68% return! I'd probably also look at the target price with the DIA only down $1 from the current price ( $101.63).  This gives me an idea how much I could make even if I wasn't completely right.

Another way to do the analysis is using the Analyze tab. This can be quite intimidating but the basic steps aren't too hard. Simply set the target trade up (Apr/Mar 100 put spread) in the trade tab and then right mouse over the little button just to the left of the 'Calendar' spread type and select 'Analyze Duplicate Trade'.

calendar spread trade analysis

This chart should display without any additional changes to parameters. What it suggests is that on March expiration, IF DIA is right at $100, then the trade (with 4 contracts purchased today at $.80) would profit just over $500. That's about $130 per contract profit, which means the spread would be worth about $2.30 on that date. That's the absolute best case scenario and would be a lot like winning the lottery. 

Position sizing

As with any of my trades, I want to select the number of strikes based on the risk in the trade and my allocated risk per trade. I allocate just 2% of my portfolio (currently around $18500). That means I can risk $370 on this trade. With an $.80 debit, that means I can take 4 contracts.

This assumes I will let the trade go no matter what happens. I've found that the calendar spread is pretty fault tolerant and I rarely lose the entire investment. Just to make sure, I could adopt an exit rule that triggers me to close the trade if the position loses 50% of the initial debit. That means that the value would shrink to $.40, which could happen if DIA rallies up strongly. If I were to do that, then I could take twice as many contracts.

When I set the trade up and entered it, I calculated the size based on maximum loss. For now, I'll go with that.

Exit plan

I've mentioned briefly some of my exit plans, including closing the trade completely if the DIA starts showing more bullish tendencies. In addition, I will look for opportunities to lock in a profit.around 40%. I don't want to get too greedy. If things are looking really good, I may close half at 40% and let it run for a few more days.

I've mentioned before that I always want to close my trades at least 4-5 days before expiration. In the case of this calendar, I'll look to roll to the next month no matter what in that window and then again on the final roll.

Just to summarize, I will exit under the following conditions.

  1. I will exit if I can lock in about 40% profit. That means I'll close if the spread widens out to $1.12.
  2. I will exit or roll when approximately 4-5 days of expiration
  3. I will monitor the position and look at exiting the spread if the DIA closes strongly above the 30 day moving average.

Portfolio Impact

Given that this calendar spread is a bearish one, I'd expect the bias (as indicated by the delta) to be negative. As a result of this and the fact that I closed the put side of my iron condor, I am now fairly bearish. However, would you believe that if the market when no where for the next 3-4 weeks, both positions would make money? That's why I love this kind of trading!

Calendar spread portfolio analysis

I will continue to monitor my portfolio and adjust as necessary. My if the market starts showing some strength, I might add some positive delta, positive theta to my position. 

Does anyone know what kind of trade that would be?

Update 2/10/2010

About a week after I first put this calendar spread trade on, the DIA dropped some and remained in the area of the short strike.

With a week of time eroding and the move toward my short strike, the spread has now widened out to about $.93/contract. Unfortunately, this is the point where I wish time would speed by with no movement in the market.

Unfortunately, that's not the way it works so I'll just need to be patient and wait. After next week, the time value on the front month option will erode much more quickly. I have a feeling, we may be seeing DIA at $100 more than once over the next month or so.

Update 2/19/2010

Since the selling of last week, we've seen a rally start to develop. The question is whether the buying will continue. A few days ago, DIA cleared a resistance area around $103 and formed a near term higher high, although not on convincing volume.

I'm considering closing this position and will likely do so if the DIA clears the next resistance level at around $105. As it stands, the value of this calendar spread still holds at around $.75. The main reason is that while the DIA has moved up, time has eroded on the short strike, which now has around 28 days until expiration. We can expect the short strike value to begin eroding much more quickly now.

Update 3/3/2010

This calendar spread continues to linger on. About two weeks ago, the DIA broke above the 30 day MA but at the time, the average was heading down. Since that first break of the moving average, there has been a pullback that found support near the moving average. While there is overhead resistance at around $105, it's looking like today is the day that will be broken.

As a result, I've closed the calendar spread position for a $.69 credit. Since I initially paid $.80 for this trade, I only lost $.11 per contract times 4 contracts is $44. I can live with that for being wrong. That's only a 13% loss on my original investment and only a .2% loss on my portfolio.

I originally put this trade on because I was bearish. Remember, that was back at the beginning of February. Since then, a lot has changed, including my bias. As I've mentioned before about calendar spreads, they have a pretty high tolerance for being wrong. The big thing is to not wait until the last few weeks to exit. The same characteristic that keeps the calendar spread from not gaining quickly in value even when right at the short strike is the feature that allows the calendar spread to retain value even when the underlying moves a ways away from the short strike.

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

Stay tuned for further updates as the trade progresses...

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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