I've decided it's time for another calendar spread. We'll talk more about why I believe this in a moment.
||Buy Spy Apr/March
130 put calendar spread
||1. Exit if I can lock in
40% ROI (i.e. roll for $1.27)
2. Exit if within 4-7 days of expiration
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.
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.
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.
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.
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.
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.
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.
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.
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?
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.
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:
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...