Another good set of questions
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
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?
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
vega 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,
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…