Is it still a Calendar Spread?

Mark,

I am wondering about proper management of a multi-month calendar spread. I initiated the position in November with selling the Nov 40 call and buying the June 40 call. The stock price at that time was around $37 and I had a bullish bias. The stock has trended up and so far the Nov, Dec, and Feb calls that I sold all expired worthless. In Feb I increased my short strike to 41, and it closed just above $40 last Friday.

So now my long June 40 call is in the money, and I will probably look to sell a March 43 call.

My question is this – if my bias remains bullish, is the proper strategy to just keep holding the long June 40 call and keep selling short calls with higher strike prices, or is it smarter to just sell the June 40 call and initiate a new calendar at the 43 strike price (sell March 43/buy June 43)? In my studying of options I haven’t seen this topic discussed – but it seems to me that replacing the June 40 with the June 43 would lock in profit and reduce risk if the price goes down from here and is probably the smart move. Would there be any good reason to not do this? Thanks.

sandeep

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Hello sandeep

I agree with your decision and no, there is no sound reason for not doing as you suggest.

There are two issues in play here. You began by purchasing an OTM call spread. This tends to be a bullish strategy because time spreads widen (become profitable) as the underlying moves toward the strike price, and lose money when the underlying moves away from the strike price. Plus, the rewards are magnified when expiration arrives with the stock being near the strike price of your short option.

The second issue is deciding which is more important: Are you buying time spreads (hoping to profit from time decay and a stock that does not make a large move in either direction), or are you making a conservative bullish play. One of these factors has to be more important than the other because they may result in a conflict. Such a conflict is apparent right now.

The calendar

If you want to own a calendar spread with a bias, then you must unload that Jun 40 call, take your profit from this position, and find a new calendar spread that suits your market bias. On a rally towards 43, sure, the Jun 40 call would increase in value by more than the Jun 43 call. But if you are trading calendar spreads, then I urge you to move your long option to the same strike as your new short option.

The Jun41/Mar43 spread should not be called a time spread. It’s more of a bull spread, with extra vega. There is simply too much downside risk for the potential reward. A calendar typically involves less risk. I know you are bullish, so if your main thrust is to be bullish then you may choose any bullish trade. I don’t see any specific benefit to this one – other than you save a small amount in commissions to hold your current long. [I believe it’s bad policy to allow commissions to affect trade decisions]

One point is that an OTM call calendar is not as profitable as an OTM put calendar. However, that put play can only be used when bearish. The problem with the call calendar is that implied volatility tends to decrease on rallies, and you own vega (the volatility component of the option’s value). Thus, as your position earned profits on theta and delta, there was probably some loss as a result of being long vega.

Nevertheless, this has been a very nice trade for you. But, as a calendar spread, the trade is finished. Take the profit and find another calendar.

The call spread

I see no reason to load up on vega when making a bull play. Those two are not allies. To trade a bull spread, you would be better off owning a March call spread. Sure it has downside risk, but less so than owning the June call.

Think about your current position. As the stock rises, it begins to take on more characteristics of a covered call. The long option picks up a lot of value – just as does owning the shares. Downside risk is large. Upside potential is limited.

Obviously your trade is nothing similar to that CC, but if the stock keeps moving higher, it begins to feel more and more as if you own a deep ITM option and are writing a front-month call as an income play.

The answer

I truly don’t have the answer for you. I believe you must choose between the calendar and the bull spread. Why own both together? Especially when a continuation of the rally should make owning the March/March call spread a bigger winner than the diagonal you plan to own. Add to that it loses less on a big decline and the calendar spread is better.

The time to hold June 40s and write a new March call is when you do not believe there is much volatility in the stock’s short-term future and you prefer to own the June call. This is a theta play. A non-rally could make the March vertical spread lose all of its value while the June option would retain a great deal of value.

I like simplicity and vote for the 43/43 calendar.

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3 Responses to Is it still a Calendar Spread?

  1. sandeep 02/21/2011 at 10:03 AM #

    Thanks Mark, that is helpuful. One follow-up question – I initiated this trade as a multi-month calendar to get the opportunity to roll the position multiple times. I had learned on some webinar that doing this is a good way to bring the cost of the long option down. I believe I have heard you mention in the past that muti-month calendars have some problems – is the issue I have now the main problem? Is it best practice do shorter duration calendars, like maybe March/April or March/May rather than getting into 3 month or longer calendars?

    Regards,
    S

    • Mark D Wolfinger 02/21/2011 at 10:18 AM #

      Multi-month calendars do indeed have problems. It’s typical of those who recommend them to ignore such problems.

      The issue you have now is not really much of a problem. This trade has worked as well as it could work. You would have a problem is the stock were 46 now. Or 31.
      That’s when it’s a problem. The calendar is a negative gamma, positive vega trade. That’s really all you need to know.

      Get a large move in the underlying price, and gamma hurts.
      Have a huge decrease in IV, and vega hurts (but the trade may still be profitable, due to theta).

      But gamma is the enemy. Big moves are the problem. You have an ideal situation, not a problem.

      Regards

  2. sandeep 02/21/2011 at 10:41 AM #

    Got it – thanks again.

    S