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Calendar spread: Protecting a short credit spread position

In
reference to Kite protection, if you were short 8 of the Jan RUT 520/530* put spreads, would a 550 Feb-Jan put calender serve as
temporary protection in case of a further RUT fall towards, but no father
than 550?

*I later learned Steve. meant the 510/520P spread, but the conversation is not affected.

I have tried generating risk graphs of OTM put calendars with OTM
put spreads, but not sure if they are accurate in their risk
assessment.

Steve

***

Hi Steve,

1) Yes.  The calendar serves as temporary, but limited protection

Consider this:  If RUT moves to 550 'and no farther' you will not need much, if any, protection.  The usual reason for buying insurance is to make the original position less risky.  When short the 520/530 put spread, RUT moving towards 530 represents the big problem.

The insurance purchased should do something that reduces the risk of owning the original trade – in the event that the potential trouble does occur.  And that would be making your position better as RUT approaches  530.  The concept of buying insurance is to generate
profits that partially offset losses resulting from the original trade.

Below is the risk graph for owning 2-lots of the RUT Feb/Jan 550P spread, with 46 days remaining before expiration:

1130_blog_one

Here's the same position three weeks later:

Two

You can see a profit at the 550 level – as anticipated when the calendar moves to the strike price.  But, where protection is needed (530), you get no help.


2) The problem with calendars is that they are profitable over a limited price range.   If the underlying moves much lower than the strike, the effectiveness of owning the calendar disappears.  If RUT were to move quickly through the strike (550) and head to your big problem area – near 530, there are two big factors that become important:

a) The calendar has already moved past it's most profitable price – and that's near 550.  Thus, as RUT moves lower, the calendar becomes worth less and less.

b) The calendar may possibly continue to maintain its value.  If IV increases sufficiently (spread is + vega) it may offset the continued price decline (the spread is + delta as RUT moves through 550).

For the calendar to provide the protection you seek, you would be advised to exit, with a profit, as RUT reaches 550 (or perhaps a little lower).    There is no point in holding 'protection' that has done what it can do – and is no longer protecting.

Bottom line:  The calendar is okay as a stand alone trade, if you want to make that play, but it does not offer quality protection.  'Quality' means it provides protection. Period, with no chance that protection disappears on a continued price decline, or the passage of time.

NOTE:  To protect the RUT Jan 510/520P credit spread, the Feb/Jan 550 P spread is even less effective than it is in protecting the 520/530P spread.

Here are the graphs combining the 8-lot credit spread with the 2-lot calendar spread:

Both_now

NOTE:  The solid line is the result at expiration, and the thin line represents 'today.'

At expiration, the calendar makes things worse and increases losses (blue line).

Four weeks from today (see graph below), you have a small profit at the 530 area – from the calendar spread.  This is not good enough.  This is not solid protection.  The credit spread is still losing.    You need protection at all times, not only for a limited time frame.

Both_4_weeks
 

3) The graphs should be accurate.  If you plot the calendars by themselves (without put spread), you can see how well they do as time passes.  And how they begin to lose some accumulated profits on a price decline.   Their effectiveness is lost when you need it most – when your credit spread is threatened.  That s the reason for the early exit – take the profit you earned and now find better protection for the credit spread.

4) Most traders who use calendars as a protective strategy, open them nearer to the 'trouble' spot.  That means the 540 calendar provides better protection than the 550.  But this is a personal choice and not a rule.  Obviously, being farther OTM, there is less likelihood that the calendar will produce a profit.  Thus, if you seek a profit, the 550 may be okay for you.  If the true purpose of the calendar is to offset losses, I believe the 550 strike is too far removed from your trouble spot.

The 530 strike appears to represent the best calendar.  The problem with that idea is that all your shorts are lumped at a single strike, and all by itself, that's undesirable.

5) If you are looking to trade the calendar as a profit source – that's very different from wanting to use it as protection.  When seeking a profit is your primary motive, then you should choose any strike price that suits your outlook for where the underlying is headed. 

If you buy any calendar spread and eventually collect your profit, that would be the appropriate time to reconsider what to do about your 8-lot spread.  If enough time passes, you could exit.  Or find other protection. 

6) The problem with any calendar spread is that this idea looks attractive, but affords no help on a big gap opening.  Not a likely event, but that comes back to your original concept:  You want protection.  Protection from what? 

A steady decline?  Then the calendar is appropriate. 

A rapid collapse?  The calendar will not help enough because it's not what I refer to as 'quality' protection.


7) When insurance is the goal – and this is my personal perspective – profit is not my motive.  In fact, I'd hope the insurance money is 'wasted' and that the position I am trying to protect never gets into jeopardy. Not everyone looks at it my way, and many want both protection and profit from the insurance – and although you can achieve that, it requires an unlikely outcome: Underlying moving just far enough, but not too far.

8) NOTE:  This is not similar to the kite spread.  The kite provides protection at all times.

All graphs plotted using free software, the Option Strategy Evaluation Tool, available from Peter Hoadley.

535

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