An Argument Against Calendars?

[mks212 0]

I have been thinking a lot about calendars lately and why they make me uncomfortable. At a basic level, you are betting that the underlying's price will not move, or not move much.

Ever since 1998 when LTCM crashed, the frequency of large, unpredictable moves in the market has increased. This is even more pronounced in the post 2008 world (think May 2010 flash crash).

What I like about straddles/strangles, is that we are playing a solid strategy of getting paid off big if IV spikes as we hope, and we don't really lose too much if the spike doesn't really occur.

The straddles also have a HUGE added bonus. If the stock moves big, either way, we also win. As a very recent example, the first JOY straddle opened a few days ago provided about an 8% return the very next day as the stock jumped to right around $57.50.

Now, back to the calendars, if an underlying has a big move, for ANY reason, you lose. While I cannot prove it, I would be surprised if the positive vega of the calendar can outweigh the large move from a crash. And with all of the program/high frequency trading going on, and the fact that nobody really knows how they interact with one and another, the risk of these types of crashes is higher.

For this reason, I get nervous when I see a calendar spread. You can do all of the correct research in the world, and then some unexpected problem comes up, and boom, you lose.

[Kim 8,043]

I assume that your concern is related to all kinds of theta positive trades (condors, butterflies etc.) and not only calendars.

You are correct that big move will cause a loss to those trades. This is expected. According to probabilities, you are expected to lose around 20-25% of the time, depending how the trades are structured. The big question is how much do you lose when you lose. You should never allow for a sizable loss, and the common wisdom says that on average, you are not allowed to let the average loss to be bigger than an average gain. So it really depends how the trade is structured (weeklys are obviously more risky), but it all comes to risk management and position sizing. Of course in a rare event like the flash crash, there is nothing you can do, but normally, markets don't crash 5% a day. If you manage the trades properly, you should be able to limit the losses, and statistically, you should have an edge as an options seller since on average, options are overpriced and over time, IV is higher than HV.

[Guest Corto]

mks,

I thought I had written that myself, and I did a few weeks ago when I decided not to take calendars! To me it is a personal decision not to. Certainly it can work, but I didn't join for those types of trades.

Mike

[coachcr 2]

Maximum risk is known at the time of trade entry - the debit. Position sizing is the key to surviving long term.

[Kim 8,043]

Maximum risk is known at the time of trade entry - the debit. Position sizing is the key to surviving long term.

Right. But in addition to position sizing, you should NEVER allow the maximum loss, not even close.

People do those trades for years with great success. I think that doing them in combination with our earnings trades is a winning formula.

[coachcr 2]

I agree and am participating in the calendars myself. I'm just saying that position sizing keeps you out of colossal trouble in the case that mks212 was concerned - large unpredictable moves, such as flash crashes.

[mks212 0]

. If you manage the trades properly, you should be able to limit the losses, and statistically, you should have an edge as an options seller since on average, options are overpriced and over time, IV is higher than HV.

I like the idea of selling IV due to your point. For example, Jeff Augen suggests many times to sell straddles/strangles to take advantage of overpriced volatility. My concern is that the the one black swan comes along and knocks out all of your profits from the trades done during normal times.

A very real example is the DIA ETF I bought in March 2003. I followed that trade for months before and got in just above the final market bottom. Best trade of my life and I rode it and felt good about it until 2008...We all know what happened there.

mks,

I thought I had written that myself, and I did a few weeks ago when I decided not to take calendars! To me it is a personal decision not to. Certainly it can work, but I didn't join for those types of trades.

Mike

You may very well have, I'm pretty new here and probably missed the post.

Mike

[tjlocke99 18]

I like the idea of selling IV due to your point. For example, Jeff Augen suggests many times to sell straddles/strangles to take advantage of overpriced volatility. My concern is that the the one black swan comes along and knocks out all of your profits from the trades done during normal times.

A very real example is the DIA ETF I bought in March 2003. I followed that trade for months before and got in just above the final market bottom. Best trade of my life and I rode it and felt good about it until 2008...We all know what happened there.

You may very well have, I'm pretty new here and probably missed the post.

Mike

You know the black swan has always terrified me. I look at guys like Taleb though, and I can't figure out how they really make money. If you for 5-7 years take 15% losses betting on a black swan all the time that will add up and bleed you to death. You can never invest 100% in gamma/vega plays or you'd go broke.

If you play 20% of your portfolio on calendars and:

1. Over the course of 6 months you have 100% Rate of Return (a 20% gain) on your ICs and calendars.

2 at some point you lose 95% of that in some crash than you have lost 19% of your portfolio.

You still come out slightly ahead. So as Kim and others have pointed out. Position sizing is key.

Obviously it has worked well for Mark W. Although I posted a question on what happened in 2000, 2008, flash crashes, etc, and never heard back.

[Kim 8,043]

You are correct, but probability of 95% loss is extremely low even during 2008 crash. Remember that the crash did not happen in one day, and with proper risk management, you should be able to limit the loss to 30-40% worst case.

[Kim 8,043]

To further demonstrate my point, lets take a look at the 820 RUT call calendar (short Dec20/long Dec27). Lets say we open it today for 2.50. Now lets assume that RUT gaps down 5% to 780. The 780 calendar which is 40 points OTM now is currently worth around 1.20. That's ~50% loss. However, lets not forget that 1) we will have a day passed so ~10-15 cents of theta will be added 2) in case of such big drop, IV will spike and increase the value of the trade.

So even with such relatively aggressive calendar (expiring only 13 days out) and 5% gap down, the trade is not likely to lose more than 40-45%. But how often does it happen?

[tjlocke99 18]

To further demonstrate my point, lets take a look at the 820 RUT call calendar (short Dec20/long Dec27). Lets say we open it today for 2.50. Now lets assume that RUT gaps down 5% to 780. The 780 calendar which is 40 points OTM now is currently worth around 1.20. That's ~50% loss. However, lets not forget that 1) we will have a day passed so ~10-15 cents of theta will be added 2) in case of such big drop, IV will spike and increase the value of the trade.

So even with such relatively aggressive calendar (expiring only 13 days out) and 5% gap down, the trade is not likely to lose more than 40-45%. But how often does it happen?

When we say how often does a 5% move happen it is based on the high/low not the closing, so that makes it more likely. Certainly it happened in the summer of 2011 a few times. The other question though is how often a 2.5% or so move happens which is still a large loss.

Kim, if we had a 5% move up would that definitely drop the IV?

[EricSimpson1 5]

Kim, is there a certain level on the VIX where you would not enter a calendar trade? I know it's rare, but my concern is that when the big market moves occur, they tend to be clustered together, and this period of high volatility can last for a few months.

[Kim 8,043]

Richard, the real concern is a gap. If the stock moves intraday, you can usually limit the loss. Yes, 5% move up would probably cause an IV drop, but it is also much less likely than 5% down.

Eric, there is no certain level, but VIX above 25 is probably less suitable for calendars. But even at those levels, you can combine the calendar with condor or butterfly which are vega negative, so you reduce the vega risk.

[mks212 0]

Let me ask a different question. There has been plenty of educational articles on straddles/strangles on Seeking Alpha and other sites and books (some of the best being Kim's). Is there any equivalent on calendars and/or butterflies?

Thank you.

Mike