Adjusting Calendar spreads

[Kim 7,943]

In this post, I shared few ideas how I trade calendar spreads. Today I would like to talk how to adjust those spreads if the market goes against you.

 

There are at least 10 different ways to adjust a calendar spread. I will assume that we started with a single calendar and 10 contracts and the stock moved down.

 

Generally speaking, I like to adjust when the price reaches the expiration breakeven point OR my loss is around 5-7%, whichever come first. We will see on the P/L charts what does it mean. The general idea is to reduce the delta to neutral or almost neutral.

 

So lets take a look at some of the most common ways to adjust.

 

1. Turn a single calendar into a double without increasing the capital. That would involve selling 5 contracts of the single calendar and buying 5 contracts of a second calendar in the direction of the move.

 

2. Turn a single calendar into a double and increase the capital. That would involve  buying 10 contracts of a second calendar in the direction of the move. This could be effective if we started the trade with half of our normal allocation.

 

3. Buy straight puts. The advantage of this method is that it is fast, involves less commissions and slippage. It can be very effective in a fast moving market. The disadvantage is that we decrease the positive theta, sometimes significantly. 

 

4. Re-position the whole calendar. That would involve selling 10 contracts of the single calendar and buying 10 contracts of a second calendar which will be ATM. I showed a case study in the AAPL rade post mortem. The advantage is that we keep the theta high since the calendar continues to be ATM. The disadvantage is that we can be wispawed if the stock revereses.

 

5. But OTM butterfly.

 

6. Reduce size. 

 

7. Take the trade off if a maximum loss has been reached.

 

Lets take a look at a case study using April 15, which was one of the worst days in the recent stock market history.

 

On Friday April 12, RUT was trading around 940-945, and you decided to open a calendar spread using June/May options and 945 strike. This is how the P/L chart looked at Friday close:

 

 

On Monday open, RUT is down 7 points and continues lower. Couple hours later, it is down 16 points or 2.3 SD. The trade is down 6%.

 

 

Time to adjust. Lets sell half of the original calendar and buy 5 contracts of a new calendar. Our delta of 10 contracts is around +60, buying 910 calendar would reduce it to ~+12. This is how the new P/L chart looks like:

 

 

By the end of the day, RUT is down 35 points or 5 SD, and our trade is down 16%:

 

 

This is how it would look without the adjustment:

 

 

That's right, down 31%. Ouch. 

 

Lets see if we could do better. How about buying a put? The 930 May put will reduce the delta to +6 while increasing the investment by about 25%. Here is how the P/L graph looks after the adjustment:

 

 

Do you see how much smoother it looks? Now lets go to the end of the day:

 

 

RUT is down 5 SD in one day, and our trade is down only 8%.

 

So how would we know that buying a put would produce better results than turning into a double calendar? Well, we wouldn't - and as we know, hindsight is always 20/20. But here is a tip: when you see after couple of hours that the market (or the stock) is in a free fall, reducing the delta by buying puts is usually the best thing to do. First, it's the fastest - only one option compared to multi-leg transaction. Second, it gives you the best protection if the stock continues lower. And if it reverses - just sell the puts. The gains from the calendar should more than compensate for the losses of the puts.

 

The bottom line is that there is no such thing as the best adjustment. The best adjustment is the one that works the best - in hindsight. But it's important to know what the options are, and use our best judgement based on the information we have in real time.

 

Let me know if you have any questions.

 

[samerh 6]

Great, thanks for this Kim.

At what point do you stop doing adjustments in turbulent markets? RUT can seesaw a lot at times and you can find yourself doing 3,4 adjustments. Is there a limit when you just decide to take it off at a small loss and save on commission expenses?

[Kim 7,943]

For a short term trade like the weekly RUT calendar that we usually trade, I would do maximum of 2 adjustments. If we reach the third adjustment, I would just exit.

[fradav 1]

Great analysis of various outcomes Kim.

 

Since you normally don't stay in these position until expiration, wouldn't a put with a shorter expiration (e.g. at date of planned exit) give you a better return  with respect to cost and gamma? 

Edited August 31, 2013 by fradav

[Kim 7,943]

The put is usually a short tactical play, most of the time it will be sold after 1-2 days. So when choosing which strike and expiration, we need to look at combination of gamma, delta and theta for the next 1-2 days and select the best possible option. Choosing shorter expiration will improve the gamma but hurt the theta. It is always a tradeoff, but it's definitely a viable option.