Important Announcement

Trade of the Week - Put Calendar Spread (10/20/2009)

Yes, I'm putting on another calendar spread trade. This is a put calendar on the DIA.

calendar spread entry

Buy DIA 96 Jan/Nov put calendar

1. Exit if I can lock in 40% on my debit (target $2.25)
2. Exit if value of trade drops 50% (i.e. $.80)
3. Roll Nov to Dec when within 2 weeks of expiration or I can roll for > $1.10 credit (approx 40% 1 month return)
4. Exit if within 4-7 days of expiration
Debit $1.56

This is a two month calendar spread on the DIA. This trade allows for a 3-4 point move down (about 300 - 400 DOW points). In addition, this is a two month calendar, which gives the trade plenty of time to develop

Why this strategy?

In the chart above, I marked off the range of movement from the last support bounce at around 94. I'm looking at a confluence of signals that suggest (but don't promise) that there could be another healthy sell-off. Here are the things I'm looking at.

  1. The volatility (measured by the VIX) is at a one year low at 20 and the last two weeks have met with falling volatility almost every day.
  2. DIA has made a sizable move since its bounce. I measure 7 points, which hasn't been seen since the bounce back in July.
  3. We are in the last few weeks of peak earnings announcements. Short of some really bullish news, the reality of the economy could act as a drag on the market.
calendar spread analysis

The put calendar spread is a nice trade to put on in this situation because it benefits both from DIA pulling back to the short strike AND from volatility increasing as that happens. As I've shown in the trade tab above, the one month return if DIA sells off just 3 points in the next 4 weeks can be pretty good.

If you're wondering how I got the view above, I've set up the trade page to show options chains as a calendar spread. Additionally, I've set one of my columns to be 'theo price', which enables some additional fields. Then I set the date forward to 1 week before November expiration and set the stock price to be $3 lower than current (about $97). I can then look at the current ask price ($.91) compared to the theoretical price on the date specified ($1.39). This suggests that in a near ideal case, this trade could return better than 50% per month under the above conditions.

Choosing the right strike prices

There are several ways to choose the strike for a calendar spread. I've mentioned that I like to pick several strikes out, usually a position that has a probability of success of around 60% (probability of expiring around 40%). However, when I look at possible places for a pullback, I want to make sure I give enough room for DIA to move without making the trade a long shot.

As the chart shows below, given the current volatility and the time frame of a month, it is still within the realm of possibility that DIA could pull back to $96 by expiration.

calendar spread trade analysis

This process of choosing the right strike is a somewhat iterative process. I may go back up to the prior step of looking at option chains for a price that I like and then re-analyzing in the analyze tab.

I should also mention that I looked at both a one month calendar and a two month calendar. The one month calendar was about $.90 while the two month calendar was about $1.59. That makes the 'per month' cost less to buy a two month calendar.

Position sizing

In the past, I have often position sized the calendar spread around a max loss of my entire trade. Since it is rare for a max loss to occur, my losses have been quite small when the trade didn't succeed, but my gain was fairly small as well.

This time, I decided to employ a slightly different set of rules. I decided to set a stop when the position lost 1/2 its value. That means my risk in the trade (per contract) is only about $.80. That means I can set a larger position size than I typically would have. 

So, a loss of $.80 or $80 per contract and a risk of $400 (2% of my portfolio) is about 7 contracts.

Exit plan

With calendar spreads, I like to set a target profit on my initial debit of around 40%. That means if I can close the entire trade early and lock in 40% on my initial investment I'll do it. I'll also consider a roll any time I can get better than 20% and ideally 30% return on the one month cost. That means somewhere around $1.00 roll value.

Of course, I always have my exit rule to close early. I've been asked before why I choose to close before expiration. I've learned the hard way that the last week of expiration can be volatile and a winning trade can quickly turn into a losing trade. I learned from the folks at Thinkorswim that most professionals are out of their front month trades the last week of expiration so I've made it a habit to close at least by Tuesday regardless of where the trade is at.

Just to summarize my exit rules, I will exit under the following conditions.

  1. I will exit when I can do so for $2.25 to lock in 40% return
  2. I will exit if my trade loses 1/2 its initial debit (closing at $.75)
  3. I will roll my short strike from November to Dec and Dec to Jan any time I can roll for better than 30% (about $1.00 or more)
  4. I will exit when approximately 4-5 days of expiration

As I've mentioned in past trades, one way to ensure that I stick with my exit rule of closing when the trade loses 1/2 its value is to put a stop order in.

calendar spread order entry

This order will remain in place until one of two things happens. If the order triggers, then I'm out losing only 2% of my portfolio. If I decide to close or roll to lock in profit, I'll need to cancel this order and consider putting another order in if necessary.

Portfolio impact

I've started to make a point of looking at the impact of my trades on my overall portfolio. One of the things that drove me to consider a calendar spread was my portfolio delta (weighted against the SPY) and my theta. I wanted a trade that would add positive delta to offset some of my down side risk. In addition, I wanted to add theta to my position and I really wanted a trade that would benefit from an increase of volatility that accompanies a sell off.

That trade is the put calendar.

Calendar spread impact on portfolio

This overall portfolio summary shows that as of entry, my delta is now fairly neutral, although slightly bullish still. However, I now have positive theta and a fairly high vega. The fact is that 3 out of the 4 trades will benefit from a move down. I'd really like to have some balance and maybe take advantage of the fact that the market can move up AND down and maybe all or most of these trades will be nice winners.

Update 10/27/2009

Well, we finally got some sort of a decent pullback as Monday continued the weakness from late last week. I put this calendar spread on for $1.56 debit and it has already widened out to $1.78. Here's the good part. I can currently roll the short strike from November to December for a $1.00 credit. That's right at my target price to do a roll. 

Given the uncertainty of things, I went ahead and rolled for $1.00 credit. This has the advantage of reducing my risk in the trade to $.56. I had a stop order in to close this calendar spread for $.75 that I need to cancel. As it stands, the worst case scenario is that I'd only lose $.56 per contract.

From here, what could happen? DIA could continue its downward move, perhapses even at an accelerated pace. DIA could also resume its upward move. Or, DIA could go nowhere for a few weeks. What would the impact of these moves be on the remaining trade?

Obviously, the ideal case would be for DIA to move all the way down to $96. In this case, I could probably close the trade early for a nice profit. If DIA moves up over the next 40 days, the trade may break even or even lose a little bit. If DIA continues in a sideways action for a period of time, the premium value of the short strike will continue to erode causing this trade to turn profitable.

I'll continue to monitor and take action according to my rules.

Update 11/7/2009

I let this update go a little long. However, there isn't that much to report. Following the pullback from last week, there has been a bit of a bounce, although not a very strong one as yet. Last week, as DIA continued to sell off, I was hoping perhaps to get a chance to close the position altogether but just couldn't get a good closing price. My target was to pick up another $1 for the final close. The problem was that my calendar spread is now a Jan/Dec and the December option simply contained too much value. Had this been 2-3 weeks closer to the December expiration, I'd no doubt have gotten a much better closing price.

Even with the DIA closing positive for this week, the calendar spread still retains its value at $.88. In fact, I could close this position for a profit, although a small one. Given the apparent resumption of the trend, I may be tempted to close 1/2 the position anyway to remove risk and lock in some profit. I'll be watching to see what next week brings. Currently, this is the only bearish position in my portfolio and I'm likely to keep it that way until there appears to be a top being formed in the market.

Update 11/14/2009

This trade is certainly trying my patience! While a calendar spread is a longer term strategy, it's tough to watch this trade do nothing.

Even with the strong move up on the DIA this last week the spread retains a lot of its value at $.77. The thing is that the short strike is a December option so to really do well, more time needs to pass before any serious selling takes place. This week coming up is expiration week for the November options. Once that's over then time value will really start to melt off the short strike.

So, over the next few weeks, I'll be looking for an opportunity where DIA sells off and the value of the remaining one month calendar spread gains to more than $1.

Update 11/24/2009

We had a nice little dip last week, but it wasn't enough to raise the value of this calendar spread much. Currently, the remaining value in the spread in $.51. Right now, that's pretty close to break even.

Calendar spreads require a lot of patience. I've had the trade on for over a month and will probably have it on for another few weeks before anything gets done with it. If the DIA manages to pull back another few dollars, then this could still turn into a nice profitable trade.

Update 12/5/2009

DIA is in a bit of a consolidation pattern at the moment. It isn't clear what will happen once this gets resolved. It's been a month since the last roll and the trade is pretty much where it was on the last update.

As I've stated, I don't plan to take any action unless there's an opportunity to close at some potential target. My objective is still to try to get $1.00 to close but I may have to settle for less. However, if DIA were to sell off $3-4, that would put me in range of that target.

There's not much to do on this trade but wait it out, remembering my risk is only about $.51 on 5 contracts.

Update 12/18/2009

It's been a little while since the last update, however not much has happened in that time. Today is expiration Friday and my short strike will most likely expire worthless. 

What that means is that I'll be left with a long January $96 put. There is still an opportunity for this trade to make money but I'm in the last stretch now.

If the DIA were to drop $2 - $3 in the next week or so, then this trade would turn into a nice winner. In the mean time, it's still worth about $.46. This trade seems like it has been on for a long time. I originally opened the trade on 10/20 and this weekend will make 2 months it has been on. It's tempting sometimes to monkey with a trade just because you feel like you want or need to do something. I've found it's best, especially with these kinds of trades to not mess around with them too much. They require a lot more patience than vertical spreads.

I'll keep monitoring and looking for an opportunity to exit the trade as profitably as possible.

Update 1/15/2009 (Closing update)

As I mentioned a month ago as being a possibility, this long put expired worthless.

I had already listed this on the 2009 trade summary page as expiring...

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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