Loving Positive Theta and Trading Calendar Spreads

Another good set of questions

1)  I am a big fan of calendar spreads because I like the idea of selling time value.

I'm sure you are aware, but other strategies allow time value to be sold, including covered all writing and credit spreads.

The definition of a calendar spread includes the requirement that both options have the same strike price.

All other variables of option prices are unpredictable, but the
passage of time is something you can count on.  Most books
describe calendars using calls, with the long position expiring only a few months after the short position.

It seems to me that using puts is more
advantageous: I can get more
for an OTM put than I can for an OTM call, therefore I'm selling more
time value.

You are also pay more for the long puts. 

An important decision: – Calendars perform poorly when the market
moves far away from the strike.  Thus, choosing OTM calls vs. puts
should be partially concerned with getting the strike price right.

Also, I have been buying LEAPS as my long position.  I look at my long put position as a life insurance policy,

That is NOT realistic.  No one hedges a life
insurance policy by selling short term policies against the main
policy.  If the market makes a gigantic move through your strike price,
you no longer have any insurance.

and I want the cheapest per month premium I
can get.  For example, this Jan I bought a Dec 2012 SPY 115 put
for approximately $19.  The cost of this insurance is just
over $.50 / month.  If I bought a 6-month put, the cost per month
would have been substantially higher.

I understand your plan.  But what are you going to do with that $19 put when the market moves much higher, IV gets crushed, and the put has declined to $8?

Am I missing something here?

You are
ignoring gamma risk – i.e., the BIG move.  Obviously calendars do best
when the market does not make a giant move.  But the market must remain sufficiently volatile such that IV
(implied volatility) doesn't decline by enough to destroy the
value of your LEAPS or severely diminish the price of the short-term puts – the options you sell every month.

This idea is so dependent on IV that it is really a vega play and not a theta play.  At least, that's how I see it.

So far, this strategy has proven to work pretty well,

Over what period of time?

but I'd be interested in hearing your opinions on using Puts and also using LEAPS.

are okay – but please evaluate how much extra you must pay for the LEAPS puts to determine whether this idea is truly better than using calls.

not for me – unless IV is very low.  Buying LEAPS options is a big play on
and future IV.

Question: Are you playing calendar spreads to play theta (as you said), or vega?  How much vega risk are you willing to take?  Only you can answer.


2)  My understanding is that
the Greeks help you understand short term movement in your overall
position.  If you set up a position with an eye towards the profit/loss
graph at expiration, the Greeks will only help you understand how your
position will react short-term.   When I set up a position, I'm not too concerned with short term movement, but only focus on the ultimate profit/loss potential….so if that's the case are the Greeks less important? 

IMHO, this is a naive and dangerous question.  Fortunes are made and lost before expiration arrives.

Greeks serve one purpose.  They allow you to measure risk.  Then, the trader accepts that
risk or reduces it.

My philosophy is that a
trader must avoid the big hit.  If you ignore
everything that happens between today and expiration, how can you avoid
that occasional big loss?

What if the
market rallies and your $19 put loses value day after day.  At what
point to do stop that bleeding?  Never?

If you plan to hold positions through expiration, regardless of risk during the interim
(I shudder at the thought, but understand it's your decision) I
believe the strategy is doomed to failure because the most important factor in your future success is how well you manage risk.

Take the gambling aspect out of the equation.  I recommend considering position risk, defining your comfort zone, and trading accordingly.  That is risk management.


3)  Finally, another question about the Greeks:  I understand Delta, Theta and to a lesser extent, Vega. 

Nutshell version:  When IV increases by one point, option prices increase by their
vega.  The more vega you own, the better you do when IV increases.

But I have a lot of trouble wrapping my mind
around Gamma.  I know the definition that it measures the change in
Delta, but how does one use Gamma to structure a position? 

It measures the rate at which delta changes. If
you are selling gamma – and you are – you want to know how much money
you anticipate losing if the underlying moves X points.

Let's say you lose $1,000
on a two point move (delta ~ -500).  Then lose $1,200 on the next
two points (delta ~ -600) and $1,500 on the next two (delta ~ -750).  If the rate at which those
losses are accelerating is too high – if the risk is outside your zone – then you are short too much gamma. 
'Structure' your trade differently.

One way to do that is to
reduce position size.  Trade 10 or 20% fewer spreads. 

Or own some
protection (buy something useful (not father OTM than your short option)
that has + gamma, even though it is going to cost some of that precious
time decay).  Even a 1-lot pays dividends on a large move.

The point is to be aware of gamma, decide if it's too high, and adjust the trade accordingly.

I need to continue studying Gamma. 

replying to questions such as you raised, it's very helpful to have an
idea how long you have been using options.  I'm sure you can see that my
reply to a brand new option trader would not be the same when the
questioner has been trading for 5 years.  If you are a 5-year trader,
I's a bad idea to not know more about the Greeks.

If new to
options, I'd encourage you to spend some time in learning to understand what the Greeks
can do for you (even though it is only to measure risk; this is

For example, Delta is easy to remember
because it's always positive for Calls, negative for Puts.  How Gamma
works is not as intuitive as the other Greeks.  I will continue my
reading on this area.

Gamma is the same for the
put and the call (same strike and expiry).  Gamma is always +.  If you
own the option, you get + gamma.  If you sell it, you accumulate negative

Vega is always +.  All options increase in value when the
implied volatility rises.  Own an option, you have + vega.  Sell it,
negative vega.

Same with theta.  All options decay.  Options have negative theta.  Sell the option, and you have + theta.  Own it and it's negative.

Tomorrow, a follow-up conversation.  To be continued


, , ,

6 Responses to Loving Positive Theta and Trading Calendar Spreads

  1. Dimitris 07/29/2010 at 10:58 AM #

    I would kindly ask for your opinion on the following hypothetical scenario:
    Let’s assume that:
    1. I have a big portfolio (> $1 mil) invested in high quality (dividend paying) stocks
    2. I’ve been trading options (SPY vertical spreads or ICs) for five years and, on average, I earn 2% on the amount risked on each trade
    3. I need extra income $12000 per year
    4. I decide to risk every month $50000, trading ICs, hoping to earn, on average, $1000 per month (=2% of $50000) or $12000 per year
    5. Considering that I can not manage easily more than 10 positions at any given time that means I have to risk (min) $5000 per position
    6. But, I consider $5000 to be too much (therefore too risky) for one single position. Normally, I prefer to risk no more than $1000 per position (trade)
    So, how could I possibly solve this “problem” (ie earning $1000 per month risking $50000)?
    Thank You very much for your support.
    PS: In reality, I have neither a portfolio of $1 mil nor five years experience in trading options – I’ve been trading ICs only for one year

  2. Mark Wolfinger 07/29/2010 at 11:46 AM #

    Hello Dimitris,
    Okay. Hypothetical situation.
    Bottom line: Under the conditions you set, it is impossible. The biggest problem is that you are thinking like a man with a $20,000 account and want answers for the man with an account that is 50X larger.
    You need 10 or fewer positions. [This is intelligent. But – how will you handle that many positions when the market is collapsing, every trade is in trouble, and you are quickly losing money? That’s too many iron condor positions]
    You want no more than $1,000 at risk, per position. [This is unreasonable for a $1 million account. Very unreasonable. So unreasonable as to not be worth the time involved]
    Suggestion: Use indexes to get some diversification. That should reduce the need to trade up to ten different underlying assets. That may encourage you (the millionaire) to put more than $1,000 at risk per trade.
    Suggestion: If that $1,000 risk limit per position is your true comfort zone, then forget iron condors. If you earned 10% per month – and that’s NOT a reasonable expectation, that would be $100 per iron condor. Total waste of time.
    Basically you want to risk $10,000 and earn $1,000 per month. That’s your real plan. To accomplish that goal, you have two choices: Get very lucky or trade very risky positions. Neither of those is a good idea.

  3. Dimitris 07/29/2010 at 12:20 PM #

    Thank you very much for your time. You confirmed what was also my opinion: that it is impossible.
    If I ever manage to have a $1 mil account, maybe I will feel quite different about risking $5000 per position!
    At present, my account is far far lower than $1 mil and my comfort zone is about $1000 per position. I usually trade +- 5 SPY contracts (ICs) and try to collect approx. $250 per trade (2-3 trades per month).
    Thank You

  4. Mark Wolfinger 07/29/2010 at 1:09 PM #

    That’s why the question was inappropriate. You want to know how to trade now, not in some hypothetical situation. If $1,000 per is your limit, then let’s work within that limit.
    About your SPY trades. You neglected to mention how wide the IC is. That’s important. When you ‘collect $250’ per trade – that tells me absolutely nothing. Is that $250 per iron condor (ok, it’s obvious that this is not the case), or $250 per an unspecified quantity (<=5) of iron condors? Please refer to a one-lot. For example, you trade SPY 2-point wide iron condors and collect about $50 per. You trade front-month (or other) options. That is something I can understand. Regards

  5. davmp 07/30/2010 at 8:07 AM #

    Hi Mark (and Dimitri),
    This discussion is something I find interesting in that I’m curious to see concrete examples of trading plans at various account sizes, risk/reward targets, amount of experience, etc. I find lots of people write about an options strategy as if it could fit in for anyone at anytime, yet clearly someone with a small net worth will have a smaller account size paired with (likely) lower risk tolerance. Whereas someone with a larger net worth may want to “risk” still a small size but has a huge risk tolerance. Etc. What might concrete trades for these people look like? Especially if they were looking for a way to implement plans with ICs?

  6. Mark Wolfinger 07/31/2010 at 10:26 AM #

    I don’t know if I can shed on light on this for you.
    for a complete reply.