Hey everyone.
This is Kirk, here again at optionalpha.com where we show you how to make smarter trades.
In today's video, I want to talk about how we make adjustments to a calendar spread that
we are currently trading.
Calendar spreads are low probability trades to begin with, but that doesn't mean that
we can’t make adjustments that increase their likelihood of success should the stock
move fast in one direction.
Here's the thing.
You have to first make a calendar spread trade in the right situation, so low implied volatility,
so that you get decent pricing in the spread and so that you have a good opportunity to
make some money.
Even though they can be a little bit lower probability trades, not to say that they're
not losing trades, but they definitely don’t have the type of probability of success that
say a strangle or a straddle does.
But it doesn't mean that we can’t make adjustments to them.
For example: Let's say that you are trading a slightly out of the money put calendar spread
and the stock then makes a huge move up very quickly.
The whole idea here is that you're trading the put calendar spread which means you’re
a little bit directionally bearish, you want the stock to go down, but instead of the stock
fading down or slightly moving down, it makes a really big move higher very quickly.
In this case, what we’ll do is we will look to possibly adjust the front month short strike
that we’ve sold when it decays in value by more than 50% or 75%.
What we'll look to do is roll that strike closer to where the stock is trading right
now.
It’s a consistent theme here with a lot of the adjustments that we do at Option Alpha.
In this case, let’s say that you sold a 203 February put strike for $255 (that’s
your front month contract because it's closer to where we’re currently at) and you bought
the back month contract or the 203 put strike for $435.
The net debit that you ended up paying for this strategy is 180, so your max risk is
still capped at 180, but we want to be able to possibly reduce that risk or cut that risk
down if the stock does continue to move higher.
What we ended up doing here is we’d roll that front month contract, that February put
strike much closer to the stock’s new price for an increased credit.
Make sure that you analyze this trade first to ensure that you still have a decent probability
of success, that your window of opportunity here with the calendar spread still looks
pretty good as far as how many days are left till expiration.
You have to be a little bit judgy, have a little bit of commonsense in here to see if
it’s realistic.
But the whole idea is that we’re taking this original calendar spread which is in
red and we’re shifting it and tilting it higher which is the dotted calendar spread
adjusted profit and loss diagram, just assuming that the stock rolls higher a little bit.
We want to take advantage of that by moving up that front month contract.
What we’re actually going to do is we’re actually going to go to our broker platform
here in Thinkorswim and what we’re doing now is just analyzing a trade that we setup.
This is in SPY which is currently trading at about 205 and we did the 203 February options
that we’ve sold and we went ahead and bought the 203 March options that are going to be
our back month.
These February options or the 203, that’s the front month, and the March options are
the 203 in the back month.
You can see that the net difference between those two is about $180.
This is what the position would look like as we start off.
You can see the stock is trading right here at about 205 and we have this calendar just
a little bit tilted towards the bearish side.
We want it to go directionally bearish and what's going to happen is if the stock does
make a huge move in this direction or goes higher, then we want to make an adjustment
to this trade.
The stock is currently trading at about 205, so let’s say that all of a sudden we see
the market really take a huge move up and now the stock is trading at about 210, so
it makes about a $5 move higher.
At this point, it’s well outside of our breakeven points.
We’re starting to lose about $50 on the trade.
What we need to do is then roll up the put side closer to where the stock is currently
trading.
I’m going to go back to these simulated trades here.
If the market is currently trading about 205, we might roll it up closer to where the stock
is trading right now.
In this case, we’d be rolling just these February contracts closer to the market.
We would not touch the current March contracts because those are the far out contracts.
We don’t want to mess with those.
We want to touch the side that we’re short or these February 203s because these are losing
value and becoming profitable, so now we want to bank that profit, roll up that side of
the trade and take in more credit.
How you would logistically do that is you would sell a credit vertical spread for February.
We just use a vertical credit spread and we adjust the strikes to 205 and 203.
The reason we do this is because the 205 is going to be our new short strike.
We’re going to sell one of those contracts and the 203, we’re going to close out and
buy which is going to cancel out the one contract that we had for February that was already
short.
It basically closes out the 203, reestablishes the 205.
You might get some sort of credit, maybe $.70, maybe $.50, something like that.
You might get a smaller credit than your initial trade.
But now you can see that that profit and loss diagram is starting to shift a little bit.
Now, it’s starting to be a little bit more shifted towards the topside of the trade instead
of looking like it did before where it just was very even over 205 and you can see it
was very neutral.
Now we’re shifting the diagram and we’re reducing the risk on this side of the trade
which is the side of the trade that the market is moving against or towards and technically
taking a little bit more risk on this side of the trade, but that's okay because if the
market is currently trading up here at 210, it's got to work through a big profit window
before it gets back down to being a loser.
We’re okay taking a little bit more risk on this side of the trade, adjusting the trade
and shifting this profit loss diagram just a little bit higher.
The key here with calendar spreads is that with this adjustment, it creates a new diagonal
spread that is skewed higher in the direction of where the stock is going, but also reduces
the risk to the side of the spread.
That's exactly what we want to do, take advantage or realize that the stock is going higher,
accept that and make an adjustment to protect our position and reduce our loss.
You can keep adjusting in the same fashion should the stock continue to rally higher
and we suggest that you take a look at our CMG case study that we did because we had
this happen with a CMG trade that we made and we adjusted I believe three or four times.
We had rolled it up and basically whittled the loss down about 75% from what it was going
to be without any adjustments, so a really good case study on making that adjustment.
As always, if the stocks move in the other direction, you can take everything that we
did in this video and basically apply it to the other side of the trade.
If the stock is moving down lower towards your position and you have a call calendar
spread, you can roll down that call side as well and take advantage of the same type of
mechanics in adjusting.
I really hope you guys enjoy these videos.
As always, if you have any questions or comments, please add them right below.
Until next time, happy trading!