Loving Positive Theta and Trading Calendar Spreads II

Part I

Follow-up: I did not mean to sound naive when I said that I don't care about short term movements.  I
tend to take a macro view of my positions.  I trade options just on
index options or index ETFs and I filter out the daily "noise."  I let the market ebb and flow and don't make too many

If the number of adjustments is sometimes > zero, then you are in the game.

I am conservative with the # of contracts so that a big market
swing is not going to cause much damage to the overall account.

Good. Position size is the #1 step when managing risk

In response to your comments about what would I do if the market
increases and my long put loses value: I would roll up my short position
to create a bull spread, presumably collecting enough premium to offset
the decline in the long position.

If I understand your plan correctly, the newly opened short put has a higher strike than your long put (hence you are now short a put spread). 
Roll too far and you suddenly have nightmarish downside risk.  Do you
really want (for example) to own a Dec 800 put against a Nov 850 put? 
How is that a calendar spread?

Be careful when adjusting. Do not own a new
position when that position has far more risk than you prefer.  It's
better to exit, take the loss, and begin again.

I would not allow my short position to get too far ahead of my long position so that the position became too risky.

That's the goal.  Not so easy to do when you want to 'roll up' the put
to recover enough cash to cover the loss from your long LEAPS put.

I did a 6-year back test of this strategy from 2004 – 2009 following this basic criteria:

1) buy 2-3 year Put ATM or slightly ITM.

This is a HUGE vega play, and to me, dwarfs your theta play.

[Side comment:  IV
skyrocketed during 2008-9.  If you  already owned your long-term put
before the IV rise, you fared far better than if you had to buy the put
when IV was near 90.  Consider the effect of this on the back test

2) sell 1 month ATM, allowing myself to roll up my short position each month so that I'm selling ATM. 

This ignores how far ITM or OTM your long option is.  Thus, it ignores
all Greeks. This may be a viable play, but it is NOT trading calendar
spreads. In a calendar, strikes are identical.  You are trading a
variety of diagonal spreads.

3) If the market declined to the point that I couldn't get $1 or so
rollover for each short put, I would close both legs and
re-establish the spread using ATM prices.  This happened during the 2008

both legs and opening a new ATM position during the crash means you had
to buy LEAPS puts when IV was HIGH.  All time record high (excluding
Oct 1987).  How could you convince yourself (in the real world, not in a
back test) to pay such a gigantic price for LEAPS puts?  How can anyone
anticipate a profit knowing that IV is going to decrease?

How can you earn a profit buying ATM puts in
a volatile market?  The strike you own soon becomes far OTM, reducing
the value of the time spread.

4)  As the market increased, I would increase my short strike price
to be ATM but would not let my short position to get more than 20
strikes ahead of my long position.

strikes?  20 SPY points is a 20% market move. Near the bottom it was > 20%.  

Please understand:  I find this far too
risky.  You may find it a great strategy, especially when you have back
tested it.  But know this:  This is not a calendar spread
This is not a theta play.  This is a play on vega. Plus, you are seldom
near delta neutral – and negative gamma continuously makes that worse. 

How can you own,
for example, a LEAPS 85 put and sell an ATM, front-month 100 put and
feel hedged?  You lose money on a big downside move and lose on a rally
with an IV crunch.

I must be missing something here.

This caps the risk.

The question becomes: Is that cap at an acceptable level, or is it too high? 

If the market increased substantially from my strikes, I would close both positions and re-establish.

Based on your comment, it seems to me that 'substantially' means more than 20 strikes.

you recognize that selling ATM options gives you the maximum + theta that you
seek, but that it comes with maximum negative gamma?  This is not a conservative

5)  I did one spread for every $2,500 of cash in the account,
thereby having enough cash on hand to handle adjustments and lower the
risk of the overall account.

see the possibility of losing half of that $2,500 overnight.  Obviously
that did not happen.  How big was the largest draw down?

This 6 year back test netted performance of approximately 25% per year.

Nice result. Do
you trust that period of time as being typical? 

Because I was satisfied with the back test, I started trading this
with real money in January of this year.  YTD, I am up almost 10%
compared to a down S&P 500.

Your benchmark is not the S&P.  Your trades have nothing whatsoever to do with market direction.

The important question for you: Is this return sufficient to justify the risk?  You may feel there is little risk, making this question easy to answer. Because nothing
terrible seems to have happened during very turbulent markets, the risk
may be less than I fear.

There is no reason to abandon a
successful strategy.  But be careful: Overconfidence can be a killer.

question remains:  Why are you making money?  It is truly from theta? 
Is it from vega?  Is it from lucky market moves?  Is it from making
skillful and timely adjustments?

This strategy is not a 'set it and forget it.'  Thus, it's important to know from whence come the profits.


Anyway, thanks again for your feedback.  I look forward to learning
more through your book which I just bought.



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7 Responses to Loving Positive Theta and Trading Calendar Spreads II

  1. Brandy 07/30/2010 at 9:55 AM #

    Terrific detailed discussion. Thanks

  2. dave appel 07/30/2010 at 7:59 PM #

    this is a great post mark. I have to say as one who has traded diagonals and calendars both this has got me thinking that i need to go shorter term on my long positions. I have used leaps and much longer dated options for a while now, and while i have done well I wouldn’t say I have outsized gains with these positions. It is because when the market moves, implied volatility is pulled from this positions. While shorter term calls (as my longs) have a higher vega then the front month, leaps can really lag. They also are victims of slippage . I like the idea of the long strike 3 month out against front month – it gives the ability to go for 3 months on a diagonal and has more positive gamma . going forward i am going to switch out to shorter term.

  3. Mark Wolfinger 07/31/2010 at 10:33 AM #

    Thanks Brandy,
    I’m never sure when there are too many details.

  4. Mark Wolfinger 07/31/2010 at 10:37 AM #

    Shorter-term longs offer less risk.
    If you want to try LEAPS again, the time to do that is when you believe IV is low and want to place a bet that it is going to increase.

  5. Henry Tzuo 07/31/2010 at 10:03 PM #

    Hi Mark:
    I guess that you are really so patient to volutarily answer so many reader’s questions. Applaud for you!!! This is what I cannot do.
    In the case above, my sense is that he ignored a lot of things in the equation. When I did backtesting, implied volatility played a key role in the results — many “look-like” perfect strategies (set and forget) were acutally distorted by various reasons. One of the reason was that I assumed “IV does not change” — while this is totally impossible.
    So I am a little bit smarter now — when doing backtesting, and simulations, I always, assume that, when assuming market drops, IV increases at least 5% to est my potential loss. When assuming market rises, it is “relatively safe” to assume that IV stays the same as now. I never assume IV drops — since I am a rock-hard credit spreader, being lucky should not be part of the backtest.
    In this “positive theta case” — If I were him, I would never do it. Theta is both a worst enemy and a best friend. WHen market moves, whether up or down, even for slightly ITM ops, time value decays, let alone deep ITM or OTM. Unfortunately, the prob of staying ATM is very low, this is even more sure when the holding period is long.
    Just a personal note: The fun of options is, there are so many variables, and the trade off of diff variables in strategy setting need a lot of brains. Many times I found that my “secret sauce” is just a piece of shit. The cycle of Trade – lose money – revise(simulation) has to play many many times to gain experience.
    When I (or other traders), can, by heart, accept that the market return is acutally a “normal distribution with a trend”, it will be a big breakthrough for this trader. “Trust yourself” does not work in option or any other financial trading. “Trust normal distribution” actually works.
    Have a great day!!!
    Henry Tzuo

  6. Mark Wolfinger 08/01/2010 at 6:08 PM #

    Although most of the ‘normal distribution’ works, the tails are far fatter in reality than predicted.
    Backtesting stock charts works especially well. The trader can find a chart pattern and ‘see’ how a specific strategy would have worked.
    With options, there is no chart pattern to duplicate. A situation that appears to be identical with another will have a very different implied volatility picture or the skew may be very different. That means the situations are not as similar it as may appear, and comparative data is less useful than one would hope.

  7. Henry Tzuo 08/01/2010 at 7:54 PM #

    Thanks Mark — I like your point: No 2 price cycles are identical. Although still an up-down as always, the reason, the volatility, the duration of the cycles are always different. The market is actually a fat-tailed bell-shape distribution, just it look very like a normal one. I totally agree. 🙂