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Consistent income trading options: Anatomy of a calendar spread

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In our quest to understand trading options for income, the topic of this article is to explore the ATM (at the money) Calendar spread (or horizontal spread) and what happens when it goes bad.

A Calendar spread is an option strategy in which you buy an option (either Call or Put) with more DTE (days till expiration) than the option you sell; both at the same strike price and same underlying asset.

In this example the underlying asset is the SPX. On Friday 1/17/14, the SPX closed at 1838.70, so we entered two positions: a Call Calendar buy JAN5 14 1840 sell JAN4 14 1840; a Put Calendar buy JAN5 14 1840 sell JAN4 14 1840. We chose this period because the SPX dropped dramatically on Friday 1/24/14, and IV (implied volatility) exploded higher (calendar spreads are positive vega, which means they benefit from increases in volatility).

From the table above, we can see that both calendars had positive P&L prior to the 24th. On the 24th the SPX dropped over 38 points, from 1828.46 to 1790.29, and both calendars (the Call and Put) went negative on the day the front (or short) option was to expire. Despite the large increase in IV (measured by the VIX), the price movement went beyond the breakeven points of either calendar.

To reduce the loss, there is always the opportunity to sell another option to bring in more premium. The choice is to close the position, or adjust and try to bring in more premium. When looking at the Call calendar, which has a loss of -$442.50, selling another Call option at 1 SD (standard deviation) would only bring in $42.50 while risking the extrinsic (or time) value left in the 1840 long Call. It would be better to just close the position rather than risk the additional loss for so little premium.

The Put calendar has to either be closed for a loss of -$165, or adjusted by selling another Put at 1.5 SD. The cost for converting the calendar into a vertical debit spread (1840/1710) is $4,610 primarily because you are buying back the short Put which is deep ITM (in the money); it's quite expensive, but it does allow you to take advantage of any further downward movements of the SPX while the short Put brings in additional premium of approximately $340. You cannot let the initial position just expire, since you will be assigned and the broker will automatically close the position down for the current loss plus additional brokerage fees.

If we decide to adjust both calendars, the Call calendar will expire with a loss of -$522.50 (increasing the loss by -$80), while the Put calendar expires with a profit of $622.50. It is interesting to note that the max gain for the Put calendar was $1,075 on the 29th, when the SPX dropped another 18.3 pts and the VIX increased 1.55 pts pushing option prices higher.

In conclusion, the probability of profit (POP) of ATM calendars is generally around 60%-65%; so closing the position down when you realize a gain of approximately 30% within a short period of time is advisable. If your calendar is losing money because the underlying is moving in the wrong direction, it is best to just close the position for the loss rather than adjust. If it is losing money because the underlying is moving in the right direction but has overrun the breakeven points (especially for Puts, where IV is increasing), then an adjustment is advisable; just understand it can be very costly to make the adjustment.

If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.

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