Trade of the Week - Put Calendar Spread (9/11/2009)

I'm putting this put calendar spread trade on with the expectation that the market will have some sort of a pullback. Yes, it's true that the market is continuing a bullish trend, but it doesn't hurt to have some bearish trades on. This isn't an extremely bearish position. It's also true I haven't done as well with managing these in the past. Hopefully, I'll be able to do better with this one.

Calendar spread trade of the week

December/October SPY 100 Put
1. If the position loses 50% of the initial investment
2. Roll when within 4-7 days prior to short month expiration
3. Close trade if I can realize a 40% return
Debit $2.27

This is a fairly decent trade with two opportunities to roll & close. I entered for a $2.27 debit, which is about $1.13 per month.

Why this strategy?

I mentioned that I believe there may be a pullback and even a decent size correction. A put calendar spread is a great way to take advantage of this kind of action. Any correction is usually accompanied by an increase in volatility. The calendar spread is one of the few premium selling strategies that actually benefits from a rise in volatility. Let's take a look at the risk graph to get a picture of how this strategy will behave.

Calendar spread trade analysis

The nice thing about this trade is that the range of profit is pretty wide. With the SPY trading at just over $104, there is room to move up to $106 or all the way down to $94. What this analysis chart shows on the green is the potential profit & loss by October expiration. If I roll this position then the P&L chart will change somewhat.

I've mentioned before that I prefer to sick with the index options, particularly the index tracking ETFs. This is largely due to the trading volume of both the stock itself and the options on them. In this case, I'm choosing to trade the SPY. 

On the calendar spread page, I mention that I prefer to trade puts for calendar spreads. This is because they benefit both from any price correction (which is a move toward the put) AND they benefit from the increase in volatility.

Choosing the right strike prices

 I also mention on the calendar spread page that I like to chose strike prices several strikes out of the money. Since I am trading puts, that means several strikes below the current price. In this case, I'm looking for a slightly larger move down so I went 4 strikes out and picked the $100 strike.

In terms of selecting the right option months, I will try to select a short month that has at least 20 days left in it. September expiration is almost here so I'll be using October for the short month. For the long month, I can either go with a one month or a two month calendar. The one month calendar would cost me $1.27 while the two month calendar would only cost $2.27, which is a cost of $1.13 per month - a cheaper choice. 

Prior to actually taking the position, I like to do a little more analysis. Since I know in setting the trade up that a two month calendar position will cost me $2.27, I'd like to know what the potential is for profit. Calculating this isn't as straightforward as with other strategies. The best I can do is run some scenarios to see what might be possible.

Calendar Spread trade analysis

I am actually using the trade page on the thinkorswim platform to perform this analysis. By setting one of the columns to 'theoretical price' I can get calculate the potential price of the options on a given date, with the underlying at a certain price and options having a certain volatility. In this case, I select this coming Monday as 5 days before expiration and I adjust the stock price down $3 from its current price and leave volatility alone. Since option pricing will be the same for any given month assuming the conditions are the same, I can estimate what the potential roll value might be for rolling October to November. In this instance, the potential roll value would be about $1.69 (2.40 - .71). If I got the same roll value each month, I could realize a gain of $.56 per month or $1.12 over the trade, which is a 49% ROI on the initial investment. This tells me this trade could be a worthwhile trade.

Position sizing

Prior to calculating my position size, I need to figure out what my risk in the trade is. I am paying $2.27 per contract (or $227). If I let the trade go completely, I could lose this much. However, if I exited early using my 50% exit rule, then I wouldn't be rising the entire amount. With a portfolio of around $20000, 2% risk would be around $400. In that case, I could take just one contract if I was willing to risk the entire trade. I could take more if I was limiting my risk on the trade. In this case, I will take just 2 contracts.

Exit plan

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

  1. I will exit when the total value of the position is 50% of the initial investment. This allows me to limit my loss to around $227
  2. I will roll the short month when I'm within 4-7 days of expiration
  3. I will exit the trade profitably if I can lock in a 40% profit

Since my track record with managing calendar spreads hasn't been that great, I'm going to work a lot harder this time on executing the trade as planned regardless of whether it is profitable or not. It's nice to have profitable trades - after all, that's why we're in the business but it's even more important to execute each trade as planned. That's what I want to do consistently. Then, the money will follow!

Update 9/18/2009

Ok so this market continues to march up without a pause. I'm a week into this trade and there's not much to report. I do want to point something out though. Since I put the trade on, SPY has moved from $104 to close at almost $107, yet the calendar has only lost  $.17 in value. 

Why is this? Because the short front month is beginning to lose value faster than the long back month. Remember that the largest rate of time decay happens in the last 30 days or so of the option's life. That's what gives a calendar spread such a broad range of profit. However, this trade won't continue to hold onto it's value if the SPY keeps moving up.

This video shows one way to manage the up side risk if SPY continues to rocket to the up side. I hope you enjoy it.

Update 9/25/2009

We've finally had a few days of the market pulling back and it looks like there is an opportunity to roll the short strike of this calendar spread from October to November.  As of this morning, I can roll this spread for $1.33, which is better than 1/2 the initial cost and is a $.20 profit on the 'per month' cost. That's about 18% return.

Calendar spread roll

That's not really a great return but at this point, I wanted to make sure I was able to lock in some credit and remove some risk on the trade. I actually put the order in and got filled at $1.33.

So, now, my cost basis in the trade is $.94. Not too bad since even if the trade goes completely bad, I still will lose less than 1/2 the original investment cost.

Update 10/1/2009

At one point yesterday, this calendar spread trade was not doing too badly with the early sell off. Now, the trade is sitting approximately at break even given my current cost basis of $.94.

It's really too early to do anything given the fact that I've already rolled to November. That leaves about 50 days remaining until expiration. Unless SPY pulls back to $100, I don't think this trade will appreciate much. Two weeks ago, I talked about a possible adjustment. This is still a possibility, but it would be for the November time frame, not the October time frame.

Update 10/8/2009

I blinked and I guess I missed the correction. This week has been pretty much straight buying. The thing with this calendar spread though is that I already rolled to November so I'm not really under any pressure to take action. Even when the SPY was at its lowest point last week the roll value wasn't that great. Let's take a look at where the SPY is at right now.

Calendar spread status

The thing to note here is where this trade is at relative to the point I entered. SPY is only slightly higher than when I entered. Yet, I've managed to roll once already and lock in some profit. Today, I could close the trade for a slight profit. That's the power of a calendar spread. I pointed this out on this week's review for the diagonal spread trade as well.

The calendar spread benefits as time goes on simply because the front month option erodes in value faster than the back month option.

So what next on this trade? Notice on this pullback that support was found at the 50 day moving average and then there was a strong bounce from there. One possibility is that the SPY will finally break above the resistance formed at 107 or so. That move won't be good for this trade I may consider closing at that point.

Update 10/19/2009

Well, the way things are looking this calendar spread looks like it could be a bust. However, a calendar spread is a much longer term trade than a vertical spread or iron condor type trade. I have a full month until my November short put expires and a lot can happen between now and then.

Since I've rolled once already, there isn't much to do really but let the trade run. Remember calendar spreads require a little more patience.

I should point out that even with SPY almost $10 away from my short strike, the position is still worth $.77. 

Update 10/26/2009

We saw a little bit of a pullback last week. In fact, last week was the first down week in a few. That has helped this calendar spread maintain some value in the face of time erosion. Time will tell as to whether there will be any sizable pullback. Here are some of the actions I'm considering.

  1. I could close the entire trade for about $.77 credit resulting in an overall loss of $.17 or $51 total. 
  2. I could close one or two contracts and leave the remainder open. This allows me to split my 'bet' so to speak. In reality, it removes risk but means I give up the potential to realize a larger gain if SPY does pull back significantly.

I'm continuing to monitor and will post an update if I take any action.

Update 10/29/2009 (Final Update)

Continued selling this week has resulted in SPY moving down to  a point where this calendar spread widened out in value. While I'm tempted to hold on a little longer to see if the pullback continues, I want to make sure I take the opportunity to lock in profit in this environment.

I closed this final leg of the trade for $1.07 credit. So let's take a moment to summarize the results. I put this trade on or a debit of $2.27. I rolled the short strike from October to November for $1.33. I then closed the November/December calendar spread for another $1.07 making the total credit $2.40. The profit in this trade then is $.13, which is an ROI of 5.7%.

Now, that isn't really a great return for this kind of trade, but consider this. I put this trade on when SPY was trading at around $105 and looked like there might be a pullback.

Calendar spread final analysis

As it turned out, SPY never really did pull back much. As this chart shows, I more or less got the roll and exit on the lows. I could have gotten a better roll price a week after I actually did the roll but it's always hard to know if 'now' is the perfect time to execute.

What this trade illustrates is that a calendar spread can be especially resilient even in an environment where the underlying stock or ETF doesn't go as planned.

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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