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Trade of the Week - Put Calendar Spread (7/20/2009)

I've been watching for an opportunity to put on a calendar spread for almost a week now. Last week was options expiration and at that time, there weren't October options on many stocks or ETFs. I put this vertical spread trade on in the first hour of trading on Monday, 7/20/2009. I was able to buy this spread for $1.72.

calendar spread on the DIA

DIA Oct/Aug  84 Put Calendar Spread


1. Exit if I can close for 40% return
2. Exit/roll 5-7 days from front month expiration
3. Consider exiting on a decisive move above $88


The nice thing about this trade is that I know going in exactly what my risk is. It's my initial debit of $1.72.

Why this strategy?

I like the idea of a bearish calendar spread to balance out some of the other positions I have on (i.e. the bulish put vertical and the neutral iron condor). In addition, the market has moved up quickly back to an area of resistance around $88 or so. With the volatility dropping to year lows, there is a good chance we'll still see another pullback. This put calendar will give me an opportunity to capitalize on that move down.

Choosing the right strike prices

According to my typical rules for calendar spreads , I'll usually look for a strike price a few strikes out of the money. I went with the $84 strike because I there was a good chance to see a pullback of at least 1/2 this last move.  The last lows were at about $81.50 and the DIA is currently trading at around $88 or so.

This position will have about a 25% chance of being at $84 on August expiration.  That doesn't mean our trade has a low probability of success though. Take a look a the risk graph for this trade.

Here we can see that there is approximately a 47% chance that I'll at least break even on this trade.  In addition, this shows that within the two break even points, I have a range of profit of about $8.50.

On top of that, I looked at taking a one month calendar spread (Sept/Aug) but the cost for just one month was about $.90 while the two month calendar was $1.72 or about $.86 per month, making the two month calendar a little cheaper overall.

The final thing to look at is the potenial profitability if the trade even goes somewhat in my direction by expiration week. I set up a quick 'what if' scenario using the theoetical price column of the trade page to see what a 1 month calendar 84 put calendar spread would be worth the Monday before expiration if the price moves down $2 from the current price.

So, even a small move down in the next 4 weeks could result in being able to roll this position for $1.34.  Remember my 'per month' cost for the spread is $.86 so that would be an apprixmate ROI for the month of 55%.  That's good enough for me to take the trade.

Position sizing

The worst case scenario on this trade is that I could potentially lose $1.72/contract. With a portfolio now of about $20500, 2% trade risk is about $410. As a result, I can take 2 contracts and remain within my risk tolerance.

Exit plan

My exit plan is to exit when one of several things occur.

  1. I can lock in around 40% within the first month  
  2. I will roll or close within 5-7 days of expiration (roll if in the first month of the trade)
  3. I am also watching the $88 resistance area and may consider closing this calendar on a decisive move above this resistance level.

The nice thing about this type of trade is that it is very low maintenance so it can work well for folks who have busy schedules or work during most of the trading day.  In a trade like this, I put the order in first thing in the morning  Now, it's just a matter of waiting for one or the other of my exits come up.  I can monitor this trade either in the morning before the market opens or after the market closes in the evening to make my exit decision.

Update 7/27/2009

Since putting this trade on a week ago, the DIA and the market in general has made another move up. The DIA has broken above its resistance level around $88. In fact, I'd say it was a fairly decisive move as the break of resistance was accompanied by an increase of volume.

I said in my exit plan that I'd consider exiting the trade on a decisive move above the $88 resistance level. In looking at the past move, we've seen a a relentless push up. I'm balancing off the chance of DIA continuing to move up against the chance that after 10 days of straight move up we may see a pullback maybe to the the 30 day MA. In addition, calendar spreads take a fair amount of patience in allowing the market to swing in the right direction. As a result, I'm inclined to give some more time to this trade before pulling the plug on it. If I was to close the trade today, I could sell it back for $1.38... a potential loss of just $.34 per contract. Given the fact that I sized the position to allow for a complete loss on this trade, I'll allow a little more time.

Update 8/3/2009

We started to see a pullback on Tuesday and Wednesday followed by a push to hew highs. Despite this, the DIA ha s failed to make any significant movement from last week.

Calendar Spread analysis

Notice how far DIA has gotten from the 30 day moving average. Usually when there is this much extension, there will be a pullback, or at least a sideways consolidation. In addition, many of the indices are hovering around the 38.2% fibonacci retracement level as measured from the highs back in October of 2007 to the lows in March 2009.

I could still close this position for around $1.30, which means the position only lost $.08 in value from a week ago. I'll continue to monitor as calendar spreads require a fair amount of patience.

This is one of the key distinctions with calendar spreads. With most other spreads, it becomes pretty clear when to exit. However, calendar spreads tend to have a slightly longer term focus (from weeks to months in many cases). As traders, we need to adjust our perspective as well. My medium term bias has become more bullish, but I also believe we're due for a pullback.

Since I don't want to make my trade decisions based just on my biases, what do I do? What are my rules when it comes to this kind of trade?  My rules say exit or roll 4-7 days prior to expiration of the front month or exit when I can realize a 40% gain on my investment. Some trade management techniques in this situation could include the following.

  • Close 1/2 now and let the remainder ride. This has the benefit of taking risk off the table.
  • Add an exit rule to close when I stand to lose some % of my initial investment (say 50%)
  • Put on a compensating or hedging trade - this can pose additional risk if the trade reverses.
  • Relax since I sized the position for 100% loss

When our back is against the wall on a trade, I think it's always good to step back, take a deep breath and review our rules as well as consider our potential options (no pun intended).

Update 8/10/2009

Still haven't hit any of my exit rules. However, I am getting close to my exit/roll date next Monday. That will be 5 days until expiration. I originally put this trade on believing that the rally was extended and due for a pullback. I was wrong. And yet... the position is still worth $.97.

I continue to wait on this position for one of three things to happen.

  1. I can sell the spread back for $.86, in which I will have lost 1/2 the original cost of the trade. That will probably trigger me to exit
  2. A week passes by and I hit my rule to roll the trade. Currently there is only $.36 in roll value, which doesn't help much. If not much has changed here, I may well exit anyway.
  3. A nice pullback occurs and I can do my roll toward the end of the week.

Until then, I'll stay in the saddle!

Update 8/17/2009

Better late than never! I've been waiting for a nice pullback and was almost ready to give up. I don't know how extended this selloff will be but it's time to see some serious selling. If this selloff is short lived, I think it speaks to the strength of this bullish trend.

In the mean time, I've hit one of my triggers, which is being 5 days until expiration. Since last week, my roll value in this calendar spread has widened out to about $.64. However, here's my quandary. I think this pullback has more strength to it than just what happened this morning yet I have a rule to roll and I'd hate to give back what has already been gained. In addition, I'd prefer to roll for at least the cost of the one month cost of the trade. I put the trade on for $1.72 or $.86/month.

Since I have 2 contracts, I can adopt a two part strategy. I'll roll one contract per my rules and wait a day to see what happens.

With the remaining contract, I'll be keeping a close eye on the market for an opportunity to get a better roll. However, it is dangerous to wait too long so it should either be tomorrow or Wednesday at the latest.

Update 8/24/2009

Ok - I have a confession to make. I didn't roll the final contract as I had planned. I had really expected a little more of a pullback. I blinked and almost missed it. At any rate, this final contract expired worthless. Now I have two long October 84 puts and one short September 84 put. The decision to delay the roll may have been a mistake on my part. It certainly leaves more risk on the table. At this point, I'm long more contracts than I'm short, leaving me with a net negative theta. That's not the position I want to be in with a calendar spread.

I'll be looking for another pullback to get that other contract sold. Alternatively, I may just close the long altogether. Are there some other strategies to explore? Remember there is always risk introduced when adopting an adjustment strategy.

I could sell a different strike closer to the money. For example, instead of selling another $84 put, I could sell a $90 put. However, that would introduce $6 of risk and require $600 of margin. Today, I could do that for about $.60. This would make the trade a little more bullish and transform it from a calendar spread to a out of the money diagonal spread. I'm going to wait a few days to see what happens.

Update 9/1/2009

Ok, the penalty for my violating my rules is that I was forced to sell my long contract and I got less for that than what I got on the roll from August to September on the other contract. With the strength of this market, it is important to remove as much risk from this trade as possible. I chose to simply sell my long put for $.56. My initial debit in the trade was $1.72. But this calendar spread was initially for two contracts so my total trade risk was $344. I rolled one contract for $.62 and sold the other long put for $.56 leaving a total trade risk remaining of $226. It may not be possible to recover the entire debit but there is a chance I can minimize this loss. Sometimes that's all you can do in a trade gone wrong. Calendar spreads are tricky and timing can be a critical factor. This is still one of my challenges but in the midst of this, I want to make sure I'm managing my risk appropriately.

Update 9/10/2009

Unfortunately, this calendar spread position continues to lose money. I finally just closed this position for a $.28 credit. With a month or so left in the trade, the odds of this turning into any kind of profitable position is pretty low. So, let's take a look at the results and then do a little 'post game analysis'.

I iniitially entered the trade with two contracts paying $1.72 for a total cost of $344. The way I managed the trade was a little unorthodox. I rolled one contract for $.62 and closed one contract for $.56 and closed the trade for another $.28. My total credits then amount to $146 leaving a loss amount of $198. That's a little more than 50% of the initial investment.

Ok, so given that this trade didn't go as initially planned, what could I have done differently? I want to first take a look at my initial exit plan. One of my planned exits was to consider a move above $88. At one point, I considered exiting but decided to stay in in favor of waiting for an exit on a 50% loss of my iniitial debit. That wasn't part of my exit plan but maybe should have been.

Why didn't I exit at the 50% loss point? It got complicated when I rolled one contract and kept the other. The truth is that in the midst of this, I lost track of my exit plan as I was trying to manage the position. Each day as I'm reviewing my trades, I should be also reminding myself of the exit plan.

It's so important to take time to review the trade plan for each trade. I've stated my plan when I entered the trade. I guess if there is one lesson to learn, it's knowing that not following the trading plan can have a negative impact on my trading results.

Since this is a closing trade, this will be the last entry for this calendar spread trade. Keep watching for new trades and updates on existing trades.

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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