Cut Cost, Reduce Risk, and Increase Reward

A principle benefit of calendar spreads is that they are simpler. One short, near-term option to every long, longer-term option. If one opens the trade above the money in the calls and has a mildly bullish outlook on the underlying, one holds a number of possibilities for profit.

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A risk graph of a number of calendar spreads in Apple options, MAR14 expiry.

The first possibility is that the price rises, toward the center of the graph. So long as the move is not too fast, a 10% profit can usually be had in the weeklies. In the two months prior to earnings when the volatility of the underlying’s options are steadily increasing, there is less risk that the graph will collapse. (Currently, Apple’s implied volatility percentile is 5%; there is not very far for the price of options to fall.)

If the price of Apple should fall and its option prices rise, then the graph will expand normally– providing one with a greater probability of profit. When this occurs, one is usually given an extra opportunity to reduce the cost basis of the longer-term option by closing the front-term option and opening another short option closer to the money to create a diagonal spread. Perhaps the spread will not make money should the price fall, but the chance of generating a scratch or small loser becomes much higher.

The key idea is that if handled correctly, calendar spreads lose a lot less than they make. What’s more, from time to time, a spread can be closed at the center of the graph near expiration. When this happens, the risk to reward is fantastic.

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A back test of the aforementioned trade scenario.
Credit: Tom Nunamaker.

To achieve the ultrahigh profits from time to time, one must risk a few more scratches or losses.  One can win over 50% of the time, provided the trades are managed well (tactics include adding additional calendar or diagonal spreads in the direction of price movement). If one falls to the temptation of taking 10-20% profits each time, the back test results look more like this:

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Back tests are gross (mis)characterizations.
Use Caution.

It may behoove one to take most spreads off at 10-20% and leave one or more on to see if it can ring the bell of max gain. I don’t know how to back test this scenario. But it is one to explore in practice, especially when the price action and the open interest suggest that the underlying will pin at a certain strike– not uncommon in AAPL, for instance.

tao

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