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Trade Tutorial - Put Calendar Spread (4/27/2011)

I think it's time to enter another put calendar spread. Any time the market shows this kind of move I have two feelings. The first is to take a contrarian trade. The other is to get on board and ride the trend. I chose the former.

Sell SPY May/June 132 put spread
1. Exit when the short strike is within 4-5 days of expiration
2. Exit if value of position drops to $.03 (limits my loss)
3. Close short strike if I can do so for $.05 or less
Debit $1.16

Given the chart above, I may end up doing both and simply closing the one that appears to be wrong as indicated by the future market move.

Why this strategy?

As I said earlier, any time I see a strong move in a direction, I start expecting a reciprocal move. Of course, the actual event is a matter of timing. In this case, I want to take an opportunity, using a longer term strategy, to be positioned for such a move if it does occur.

The calendar spread is a nice strategy to use when more time is required. With the long strike placed farther out in time, the trade ultimately may have 6-8 weeks to develop. This is a little bit longer than a typical vertical spread. Additionally, a calendar spread can be fairly tolerant of adverse moves in the early phases. If it turns out I'm obviously wrong in the first week or so, I can expect to close the trade with a relatively small loss.

Why the SPY? It really could have been any of the index ETFs. However, the SPY represents a broad basket of large cap stocks.

Choosing the right strike prices

The trading plan I employ for trading the calendar spread calls for finding a short strike having at least 20 days until expiration and a probability of expiring of about 30% or so. This probability of expiring is a flexible number. The key thing is balancing this percentage with a the target location where the underlying is likely to fall in the a time period near expiration.

The choice of a long strike is relatively easy. The price is a given. The issue is deciding how long we want the time period of the spread to be. A June strike would construct a one month calendar spread with about 7 weeks or so in duration and one opportunity to roll/close. I could look at a 2 month strike by buying a July long option. This would make the duration about 11 weeks and offer two opportunities to roll.

The problem with looking at a longer term trade is twofold. The first issue is the duration may be longer than I want given the market outlook. The second issue is that the cost of entering the trade increases noticeably.

For the purpose of this trade, I'm going with a one month trade, which means I'll be buying a June long strike. The current cost of this trade looks to be about $1.16 per contract.

Risk/Reward analysis

Before entering the trade, we want to take a look at the potential return. The problem with a calendar spread is that calculating the potential profit depends on a lot of factors including where the underlying might land on the roll/close date. The best way to calculate potential reward is to pick a point in time and a target price in order to project the probable value of the spread.

Fortunately the thinkorswim from TD Ameritrade platform offers an easy way to do the analysis. The trade page provides a means to pay 'what if' with the position. To set this up, I performed the following steps.

  1. Set one of the columns to 'Theo Price'. This activates several additional selection items, which we'll adjust in a few steps.
  2. Change the spread type to 'Calendar'. This allows us to effectively price a 1 month calendar spread.
  3. Adjust the date to the Friday before expiration (5/13). This will cause the theoretical price of the calendar spread to reflect the price as it might be on the selected date.
  4. Adjust the stock price down by $2, which would project the price of the SPY to be $132.90 or so on the selected date.
  5. The theoretical price reflects the price the calendar spread might be worth if time moved forward to the Friday before expiration and the SPY dropped $2. This projected value is $1.55, which is a projected profit of about $.39.

With a projected profit of $.39 and an invested amount of $1.16, I now have enough to calculate reward/risk. This ratio is 33%. That's not a really great reward/risk for this kind of spread but it's also not too bad given the timeframe we're working in.

Position sizing

As always, I limit my risk in every trade to just 2% of my overall portfolio value. The current value of my portfolio is $16,954. That means I can risk $339 in this trade. With a risk per contract of $116, I can technically only enter 2 contracts. However, 3 contracts would risk only $348. I can ensure that I don't lose more than my intended $339 by ensuring I close the trade if the cost to close drops to $.03. I think I can handle that!

Exit plan

I don't have a lot of exit rules for my calendar spread strategy. Typically I will close or roll the spread when the short strike is with 4-5 days of expiration. In this case, I'm also employing another exit rule, which is to ensure the loss is limited to $339.

To summarize, I will exit under the following conditions.

  1. I will exit when the short strike is within 4-5 days of expiration
  2. I will exit if the value of the spread drops to $.03 per contract
  3. I will close the short strike if I can do so for $.05. This leaves the trade open to develop further. However it also leaves an uncovered long position, which could be a wasting asset.

Portfolio Impact

This trade is a bearish trade, which means I expect the delta to be negative. No surprise that the portfolio overall is more negative due to adding this trade.

Notice also that this is a positive theta trade, which adds additional positive theta to the trade. I wanted to point out that calendar spreads are positive theta, which means they benefit from an increase in volatility. As a rule, when markets sell off, the volatility increases, which will be a benefit to the overall portfolio.

Update 5/5/2011

We've seen a bit of a pullback over the last few days, which isn't surprising given the strong buying of late. As I looked at the market and this position yesterday, the question that came to my mind was whether we were done with the selling.

The problem is that the trade hasn't been in place for that long, which means the short strike hasn't hade that much time to melt away. We're still two weeks away from expiration so a lot could still happen. How do we deal with a situation like this where there is some uncertainty regarding whether to take some profit now or wait?

I've mentioned this strategy before but why not do both? What I've done is sold one contract (out of the 3 I initially entered). I've sold this one contract for $1.37, which is a $.21 profit (for just the one contract). It's possible I may have been premature and the price I'll pay is giving up some future gains. It's also possible that the SPY will bounce and the remaining position will loose value. In this case, I've risked my existing gain on the remaining two contracts by staying in and holding out.

That's ok at this point. A calendar spread trade requires patience. So for now I'll simply stand firm with the remaining two contracts and see what opportunities the market offers.


Update 5/17/2011 (Closing update)

The pullback of the last week or so has brought the SPY to almost right at the short strike and this provides the perfect opportunity to close the remaining two contracts of this calendar spread.

I was able to get $1.73 credit for this spread. Since I paid $1.16 debit to enter the trade, I made $.57 per contract or $114 on these two contracts. Just about a week ago, I closed one contract of this trade for a profit of $21 for a total profit of $135 or an average of $.45. That means my realized ROI on this trade is 38%.

In concluding this trade tutorial, I want to go back and discuss the strategy I employed of closing just one contract earlier when the trade was showing some profit. I mentioned in the previous update that the decision to close early to lock in some profit poses a risk of missing out on future gain. The benefit of splitting this decision and closing a portion of the position means I can both close to lock in profit and stay in the trade to realize additional gain. Of course I would have made more had I remained fully in the trade but hindsight is 20/20.

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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