Hold-Through Earnings Calendar Trades and Closure Issues

[Dave W]

@Yowster or others,

I'm hoping to get some advice. I occasionally trade unofficial hold through earnings (HTE) calendars and have run into a recurring issue. After earnings, sometimes the price jump in the stock results in my calendar becoming deep in the money. When I try to close out the deep ITM calendar, the market makes it very difficult or impossible for me to close out at a reasonable price.

 

For example, this recently happened to me on RHT. I had an 82C calendar spread March 31 short / April 7 long and at the close before earnings on March 27 the stock price was $82.32. About an hour after the open on March 28, RHT stock was at $86.93. So my 82C were $4.93 ITM. But the mid-price to close out the spread was in a kind-of 'backwardation' (yes, I know that isn't the exact right term, but the situation seems similar). The mid for the short leg was $5.00 and the mid for the long leg was $4.90, so a debit of $0.10 to close the spread. Paying a $0.10 debit to close the spread (or even closing at $0.00) seemed unreasonable given that if I held the short leg through expiration, any premium to close the short options would be gone and hopefully the long option would recover some premium ($0.10 to $0.15 based on my review of other RHT options in different time periods).  So I held the spread through expiration and got assigned. I closed out the position the following day using a combo stock / option order on TOS.

 

I'd like someone who has done a number of these HTE trades to help me understand:

 

1. Has this ever happened to you? How would you recommend closing the trade when the price to close out the calendar spread is "way off" from what seems reasonable (e.g., having to pay a debit to close)?

 

2. If I do hold through expiration and get assigned, am I still 100% covered by the long option? In other words, will the changes in the long option prices offset changes in the short stock position exactly? I'm guessing the answer is no, but I haven't really looked at this yet and am not sure the best way to model it.

 

I appreciate the advice. Thank you!

Edited April 4, 2017 by Dave W

[Yowster]

@Dave W Yes, this scenario has occasionally happened to me.  Here are a few thoughts to closing out the trade at a reasonable price:

• Realize that bid/ask spreads are typically much wider than normal on the morning after the earnings are released.  It can often take multiple hours for them to get back to close to normal widths - especially for stocks that don't have big options trading volume or OI.
• Look at the value of the OTM calendar at the same strike (in your case look at the value of the 82 put calendar) and use that as a starting point for your limit order to close you ITM calendar.   Sometimes put and call calendars have different prices (due to dividends or other things) but when your strike is farther away from ATM then that difference doesn't matter so much.  If you don't get filled at this price, lower your limit order by small increments until you get filled.   In practice, you should never have to get filled at a debit to close a calendar, regardless of what the mid-point price is.

Regarding being covered on assignment - I believe you are totally covered.   For example, after assignment you are short 100 shares of RHT at a price of $82.  But you also have a long call that allows you to buy 100 shares (and cover your short) at $82.   So your excess value is whatever time premium is left in that long call (provided that you close both positions at the same time).  In your case, since it was only a 1-week calendar you're not going to have much time premium unless the stock price drops quite a bit.   But worst case you would be getting out at the same price, which is the same as closing the calendar spread at zero (and ignoring any margin interest you have to pay on your short stock).

 

I should note that for these HTE calendars, I typically go more than one week out with my long leg because when it's only one week difference the post earnings IV drop will hit the long leg significantly too.  By going out to the next monthly the IV drop hits the long leg much less.   This also means it takes a much bigger stock price move to have the calendar be worthless when compared to the move it takes to make a 1-week calendar worthless.

Edited April 4, 2017 by Yowster

[Dave W]

@Yowster,

 

Thanks for the detailed answer. Very helpful. To clarify one point, ...

Quote

In other words, will the changes in the long option prices offset changes in the short stock position exactly?

 

The point you made, and I agree, is that I am covered by the long leg so I can't incur huge losses. But implicit in what you said, and was really what I was getting at with the quote immediately above, is that any time value in the long option is 'at risk', so the changes in the total value of the long option will not "dollar for dollar" offset the changes in the short stock position. Agreed, with one week to expiration this might not be a huge deal (although $0.10 for 1 week of time could represent a significant part of the potential profit), but I also typically use a 2 - 4 week difference in time between the front and back option when I HTE (the example above was an exception). For me, this is a risk that needs to be considered when I determine whether to do an HTE calendar that I hadn't previously considered (and another risk that typically doesn't come into play in the standard SO pre-earnings calendars).

 

Again, thanks for the detailed answer. Much appreciated.

Edited April 5, 2017 by Dave W