Important Announcement

Trade Tutorial - Put Calendar Spread (2/09/2011)

I've decided it's time for another calendar spread. We'll talk more about why I believe this in a moment.

Calendar spread on SPY

Buy Spy Apr/March 130 put calendar spread
Target ROI
1. Exit if I can lock in 40% ROI (i.e. roll for $1.27)
2. Exit if within 4-7 days of expiration
Debit $.91


Why this strategy?

We've seen a rather prolonged bullish move lately. In fact the SPY has pulled quite a ways away from the 30 day moving average. With the lower volatility and this kind of extended move, I believe we'll see a pullback soon.

As we've seen with calendar spreads, they benefit from an increase in volatility (positive vega). As a result, a put calendar spread is a nice way to take advantage of this kind of pullback. When markets sell off, the volatility increases even as the price is dropping. This can give this kind of spread a nice boost.

Choosing the right strike prices

When I'm looking for a strike price to locate the calendar spread at, I typically look at a couple of different factors. My trading plan calls for locating a short strike in the front month that is at least a few strikes below the current trading price. For me, it's a bonus when I can find a point where logical support would be found. Remember that the $130 level was previously a resistance level that has since become new support.

I consider this a medium term trade so I'm only going to buy a one month calendar spread. That means the one roll I make will close the position. To buy this one month calendar will cost me $.91.

Risk/Reward analysis

As we've seen in past calendar trades, the analysis can be the trickiest part. I'm going to demonstrate how to do a quick analysis from the ToS desktop platform. However, if you don't have access to it, I'd recommend having a look at my strategy page where I talk about how to do this using the OIC position simulator.

This analysis can be made directly from the trade page on the ToS platform. To begin, set the spread type to a 2 month, 1 strike calendar. We have to set it for 2 months this time because SPY has March quarterly options and I want to calculate a roll from March to April.

Calendar spread trade analysis

As we can see above, the potential roll value if we move to the Friday before expiration and decrease the price by $1, this would simulate a condition where time has moved forward a month and the price has dropped. The theoretical price is $1.37. That means theoretically, I could sell the spread back for a profit of $.46 or an ROI of 50%. That's not too bad.

Position sizing

As always, I begin the process of calculating my position size by allocating 2% of my current portfolio value. The portfolio is currently at $17,129, which means 2% is $342. Since this trade will cost $.91 to enter and this amount represents the maximum loss, I can enter just 3 contracts.

Of course, if I manipulated my exit rules to close with a loss limit (like 50% of the debit), then I could potentially take more trades. These days I've found I have more things going on and it becomes more difficult to manage trades this way. As a result, I believe I will simply enter the trade using the maximum loss to position size and consider rolling to close when I get within the 1 week window.

Exit plan

One of the nice things about a calendar spread is the relatively low maintenance required. For a one month spread, all I need to do is monitor the trade daily and plan to exit when within a week before expiration.

One exception is I can close the trade for a reasonable profit at any point during the life of the trade. We've already seen that the target closing price could be as much as $1.37 and a profit of $.46. However this leans a little the ideal side. If I could close the trade at any point for a profit of 40%, I would do so. Since the initial trade is entered for a $.91 debit, 40% would be $.36, which means I will close to lock this in for a total credit of $1.27.

To summarize, I will exit under the following conditions.

  1. I will exit when I can do so for $1.27, which represents an opportunity to lock in 40% ROI.
  2. I will exit when approximately 4-5 days of expiration

Portfolio Impact

At the time I entered this calendar spread trade, I had no other trades going. That means the portfolio greeks are the same as the position greeks for this trade.

Calendar spread portfolio analysis

The big thing to note is that this position has negative delta in keeping with my short term bearish outlook. It also has positive theta, which I try to achieve in all my trades. Finally, note the positive vega value. This means that the position will benefit from an increase in volatility.

This is the perfect opportunity in my mind for a bearish trade, which will cause this trade to benefit in three ways.

  1. Bearish move (negative delta)
  2. Passage of time (positive theta)
  3. Increased volatility, which typically comes with bearishness (positive vega)

Update 2/23/2011

If you've been following this trade, you may be wondering if today was a good day to roll the calendar spread to close the position. I was wondering the same thing for a few moments.

Here's the deal though. While the SPY has dropped to nearly $130, there are still more than three weeks until expiration. What that means is that the value of the spread hasn't widened out enough to allow it to achieve the target profit.

What are my choices?

  1. I could close the trade now for about $1.15, which means about $.24 profit per contract or $72, which would be an ROI of 26%. That's not too bad but not the target profit we originally were going for.
  2. I could wait a little longer and see what develops. From this point, the SPY could continue to sell off more, or the SPY could rally from here - or - it could fall into a sideways range. This latter scenario would be the most desirable of course.
  3. I could find some sort of adjustment strategy, however I think it's a little too early for that.

I'm going to wait at least another day to see what happens. Even if the market sells off, I doubt it will be a prolonged selloff.


Update 3/2/2011 (closing update)

Ok, I've decided to go ahead and take my profit at this point. I'm closing for just slightly less than my target profit but that's ok.

Remember in my last newsletter that I talked about knowing when to close if the actual target has not been reached. In reality, the credit for closing was only a few pennies away from my target and the market was looking like it was going to resume the rally. This means the value of the put calendar spread will decrease. It seemed like a good time to lock in the profit.

Since this is only a one month calendar spread, this closes out the position. I entered the trade for $91 debit and closed the trade for $1.25 credit. That's a $.34 profit, which translates to a 37% ROI in just a few weeks time. I could stand a few of these! By the way, that's a total profit of $102 on the trade.

I want to conclude this tutorial with a review of the considerations for managing the trade from the last update. I mentioned that I could simply close the trade at that time for smaller profit (but locking in what I had), I could wait to get a better price, or come up with some sort of adjustment. In this case waiting turned out to be the best approach. However, had we not had this latest selloff, that wouldn't have been the case. I point this out because every decision comes with a risk. For example:

  • Close early to lock in smaller profit.
    Risk: Missing out on potentially larger profit.
  • Wait for a better price.
    Risk: I could lose my existing profit.
  • Adjust the position.
    Risk: I will likely trade some of my exiting profit for protection.

I point this out because there is no perfect answer to this situation. Every decision comes with an associated set of risks. I've mentioned in the past that there are ways to 'split the decision' by taking action using only part of the position. For example, I had bought 3 contracts on this trade. I could have closed one contract last week to lock in profit. This week I could have closed one more contract and waited to see if I could get a better price on the third. This is all part of trade management, which I'm currently talking about in the monthly newsletter (due out today).

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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