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Trade of the Week - Call Calendar Spread (4/15/2010)

I'm introducing a bit of a different trade in this call calendar spread. I don't usually trade call calendars but in this case, I wanted a bullish trade that might give me a little more flexibility time wise than other trades.

Calendar spread setup on the SPY

Buy Spy June4/May $123 call spread
1. Exit if my trade loses 50% of the initial debit on an up side move (i.e. close for $.56)
2. Close if I can lock in 40% ROI (i.e. $1.56 or better)
3. Roll if I can pick up an additional $.30-.40 crecit
4. Exit if within 4-7 days of expiration
Credit $1.12

This is slightly more than a 1 month trade. By using the June quarterly for my long position, I have the chance of an additional roll.

Why this strategy?

I started out looking for a trade that I could use to hedge my existing SPY iron condor position to the up side. In a prior trade on the SPY, I had put on a a calendar spread that didn't really help that much since SPY blew through the upper strike and past the short strike on my calendar spread.

It got me looking at a calendar spread that assumed a similar strong move. As I looked at the trade, I decided that this trade could both stand on its own and act as an up side hedge on my other trade.

There is risk in this trade. Since the SPY has had an explosive move to date, there is the risk that the move is over. There is even the risk that the SPY could turn and plummet. The nice thing about a calendar spread is its tolerance for not exactly hitting the target and still making money - or at least not losing a lot.

Choosing the right strike prices

I actually started out choosing the strike price based on a target price of $123. I simply said "what would happen if the SPY jumped over my long strike?"

Once there, I started my analysis. A 1 1/2 month calendar spread (June quarterly/May) for the $123 strike costs $1.12. That's my starting point for the analysis.

Next, I have to ask what the spread might be worth if I'm near expiration and within $1 of the strike price. It turns out this kind of analysis is pretty easy on the ToS platform. Since all options are priced the same (given the same circumstances), I can judge the potential value of the calender a month from now by looking at a similar calendar spread (May/Apr $123 call).

Below is the option chain in calendar spread view. I've added the 'Theo Price' tab. By doing so, I get access to some fields where I can adjust the date, target stock price and volatility. By simply moving the stock price of the SPY up $1, that would put me near $122. The theoretical price of this calendar spread could be about $1.45. With a cost of $1.12, that would be a target profit of $.33 and an ROI of about 29%

Calendar spread strike selection

That is enough to tell me that this trade has a reasonable chance of turning a nice profit if the market is in the general area it is now.

Risk/Reward analysis

Since it's pretty difficult at this point to determine how the SPY could behave given the prior move, I'd like to see a risk graph that gives me a lot of latitude to the up side or the down side.

Calendar spread risk analysis

As a stand-alone calendar spread trade, this shows me that my range of profit is between about $120 and $126. That's pretty good by itself. In the context of my iron condor trade, it gives me even more room to the down side. The SPY could trade down to $119 and the loss would only have a small ($100) impact on the iron condor trade.

Frankly, if this trade only managed to break even or lose a small amount, it would be worth it for the protection the trade offers.

Position sizing

On some of my calendar spread trades, I have been using 1/2 the cost of the calendar as the basis for risk on the trade. I do that by instituting an exit rule to close the trade if the credit to sell back the calendar reaches 1/2 the debit to buy it.

While I will probably be executing this rule, I am still going to only buy 3 contracts for a total risk of $336. I'm doing that because this is a hedge on another trade. I'm also doing this because I want to leave the door open to another calendar spread (either a put spread or call spread).

Exit plan

Before talking about the exit plan, I want to spend a little time exploring the potential movements the SPY could take.

  1. The SPY could continue it's strong rally and could in fact end up quite a bit higher than $123
  2. The SPY could end up approximately where it's at right now at around $121
  3. The SPY could sell off mildly down to the $118/117 level before resuming an upward move
  4. The SPY (along with the market) could sell off heavily retracing a larger move down to the $110 level
  5. The SPY could sell off strongly and then rally back

I list all of these eventualities so that I can discuss how I will respond. Keeping in mind that my original iron condor was a $122/120/113/111, the ideal landing point would be somewhere between the short strikes ($113-120). As a matter of fact, I've already closed the put spread, so any move to the down side would be fine.

The ideal scenario for this trade coupled with the remainder of the iron condor is for the SPY to sell off to the point where I could close the call spread and then have it rally up to near $123. The only scenario that wouldn't help both position is one where the SPY pushes above $124 level or so. That's the point when the calendar spread can't help the loss on the iron condor.

As a result, I'm going to focus my trade management on the up side risk. In that case, I will close the trade if the SPY pushes to the up side such that it loses $.56.

As I would with any calendar spread, I will also look for opportunities to roll or close for a nice profit. That would mean closing the calendar entirely for a 40% profit (a $1.56 target close). I would also look for an opportunity to roll the short May $123 strike to June for a $.30-.40 credit. Doing this would help cut my risk in the trade.

In summary, I will exit under the following conditions.

  1. I will exit when the SPY moves strongly to the up side such that the value of the calendar drops to $.56.
  2. I will exit when I can do so for $1.56 credit or better.
  3. I will roll the short strike to June if I can pick up about $.30-.40 in additional credit
  4. I will exit when approximately 4-5 days of expiration

Portfolio Impact

This calendar spread adds an interesting dynamic to my portfolio. Remember that calendars are positive vega positions (more on option greeks). As a result of adding this trade, my portfolio now has a slightly positive vega bias to it. That means the portfolio could benefit from a spike in volatility (all other things being equal)

Calendar spread portfolio impact

Not as obvious is that the delta is less negative since I added a trade with positive delta. As always, this trade adds to my positive theta as well.

If I haven't said it enough, I often choose my strategy based on the impact I desire to make on my portfolio greeks. Every trade I put on should add positive theta. From there, I chose the strategy based on what I want to happen to my delta and vega.

I am not a 'delta neutral' trader but I believe in keeping my portfolio greeks in a range that is consistent with my future expectation.

Note: I didn't get this trade write-up finished until after the Friday market close. As a result, I got to see a significant sell-off, which doesn't directly help this position right away but is good for my other positions. As a result, my portfolio now has a slightly positive delta. Can anyone guess why?

Update 4/27/2010

The market has been up and down over the last week or so. The main thing is that time has passed and that's allowed the spread value to widen out a little.

At this point, there's very little to do except wait for more time to pass and maybe look for an opportunity to roll the short May call to June. I'll be wanting to do that whenever the opportunity presents itself now because the back month option is a June quarterly option so there won't be much time difference between long and short if I don't do it soon.

Update 5/26/2010

There hasn't been much to report on this trade until recently. The market has sold off pretty heavily leaving both the long and short strikes quite a ways out of the money. As a result, the May short $123 expired worthless last Friday.

So, I'm left with a June quarterly $123 long call. Assuming the market can rally sufficiently over the next month, this trade can still make money. If the market stays in a depressed state, then this calendar spread will turn into a loser. The good news is that there's a fair amount of time for this to happen.

Depending on the strength of any kind of bounce, I may turn this calendar spread into an out of the money diagonal spread by selling a June short position at some price lower than $123. While this will pick up some additional credit, it also introduces risk in the form of the spread between the short and long strikes.

Update 7/11/2010 (closing update)

This option actually expired the end of June but I had forgotten about it. This was originally a call calendar spread that ended up way out of the money with the big sell-off.

I mentioned briefly in the trade tutorial summary page that I should have closed this trade much earlier... or at least adjusted the trade into something else. When I put the trade on, I expected the risk to be to the up side and had a rule in place for a strong move over the short strike. I was not very vigilant on this one as I was paying more attention to the other trades that were at risk.

So when should I have exited this trade? Let's take a look at the SPY chart above. There were at least two good opportunities to close or adjust this position. The first was a few days before the 'flash crash'. At this point, the SPY had broken below the consolidation area that had been established over the prior few weeks.

The second opportunity if the first one was missed would have been to sell into the bounce when it began to fail. Of course it's always easy to see these opportunities in retrospect. However, if I were following more strict technical entry and exit rules, these would have been clear exit signals.

Besides exiting, what else could I have done to manage this trade? One consideration would have been to roll the short strike down a few strikes to create an out of the money diagonal spread. It would have added risk to the position but would have also added premium and reduced my cost basis in the position.

Just as an example, if I would have rolled the short May 123 call down to a short June 123 on 5/4 when the first support level break occurred, I could have picked up a credit of $1.35. That means I would have been in the trade for a small profit. My guess is that I could have closed the position a few days later to lock in that profit.

Note: I used the new OnDemand feature to go back and evaluate this trade. If you have a funded account with Thinkorswim, check it out for yourself. If you don't have an account... get one. This is the coolest new feature to debut in a long time.

In terms of how this trade actually turned out, it ended up being a complete loss. I bought 3 contracts of the calendar spread for $1.12 and it expired worthless. That means this trade lost $336. While painful to experience this kind of loss, it is within my 'per trade' portfolio loss limit.

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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