Last week our string of 12 consecutive winning PEA Plays (Pre-Earnings Announcement) was broken, not because our model guessed wrong on where the stock (LULU) would go after the announcement (down, as it did), but because the CEO announced her retirement and the stock fell almost 20% on that news (the company actually exceeded estimates on earnings, revenues, and guidance but the retirement news overshadowed that good news). Our option positions were set up to handle a 7% drop and still make a gain, but we could not handle a 20% drop.
Interestingly, our loss came about not from our basic diagonal spread (where we would have made money in spite of the huge drop) but from the insurance calendar spreads we placed “just in case we were wrong” about the direction the stock would take. If we had had more faith in our model, we would not have made the insurance purchase, and we would not have suffered a loss.
Our loss on LULU was slightly greater than the average gain we made on the 12 previous PEA Plays, so while it was an unpleasant setback, it was not devastating.
How to Make a Portfolio of Calendar Spreads Either Bearish or Bullish:
At Terry’s Tips, we use an options strategy that consists of owning calendar (aka time) spreads at many different strike prices, both above and below the stock price. A calendar spread is created when you buy an option with a longer lifespan than the short option that you sell against your long position with both options at the same strike price. We also use diagonal spreads which are similar to calendar spreads (except that the strike prices of the long and short sides are different).
We typically start out each week or month with a slightly bullish posture since the market has historically moved higher more times than it has fallen. In option terms, this is called being positive net delta. Starting in May and extending through August, we usually start out with a slightly bearish posture (negative net delta) in deference to the “sell in May” adage.
Any calendar spread makes its maximum gain if the stock ends up on expiration day exactly at the strike price of the calendar spread. As the market moves either up or down, adding new spreads at different strikes is essentially placing a new bet at the new strike price. In other words, you hope the market will move toward that strike.
If the market moves higher, we add new calendar spreads at a strike which is higher than the stock price (and vice versa if the market moves lower). New spreads at strikes higher than the stock price are bullish bets and new spreads at strikes below the stock price are bearish bets.
It does not make any difference whether puts or calls are used for a calendar spread – the risk profile is identical for both. The key variable for calendar spreads is the strike price rather than whether puts or calls. In spite of that truth, we prefer to use puts when buying calendar spreads at strikes below the stock price and calls when buying calendar spreads at strikes above the stock price because it is easier to trade out of out-of-the-money options when the short options expire.
If the market moves higher when we are positive net delta, we should make gains because of our positive delta condition (in addition to decay gains that should take place regardless of what the market does). If the market moves lower when we are positive net delta, we would lose portfolio value because of the bullish delta condition, but some or all of these losses would be offset by the daily gains we enjoy from theta (the net daily decay of all the options).
Another variable affects calendar spread portfolio values. Option prices (VIX) may rise or fall in general. VIX typically falls with a rising market and moves higher when the market tanks. While not as important as the net delta value, lower VIX levels tend to depress calendar spread portfolio values (and rising VIX levels tend to improve calendar spread portfolio values).
Once again, trading options is more complicated than trading stock, but can be considerably more interesting, challenging, and ultimately profitable than the simple purchase of stock or mutual funds.
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