Calling Mr. Fixit - help on a Double Calendar trapped in illiquidity

[TrustyJules]

Ok first of all I hope you guys all have a good laugh at my expense when I explain the predicament I got myself in. I am laughing at myself as well but just out of darn stubbornness I want to see a way out of this with paying as little learning money as required.

Last week - following some books I had been reading and in the context of the low volatility environment we are in - I thought to do a small experiment regarding Vega, double calendars and earnings. The fundamental idea is simple:

- running up to earnings the volatility of options goes up - this is a continual process but accelerates as of 7-10 days before the announcement;
- it is frequent that stocks are kind of stable in their pricing as of a week or so before earnings as the market awaits the outcome;
- a double calendar is vega positive - so increasing volatility benefits a double calendar;
- double calendars have broad P&L (as long as IV doesn't collapse) and it seemed hard to lose one's shirt;
- obviously you get out of the trade before the earnings announcement and for the rest you fix the trade as per your normal rules for Calendars if necessary.

Now what I wondered was how differently options react if you do this with weekly options or on a stock that has just the regular monthly one. Back-testing is wonderful of course but as anyone will tell you nothing is more clarifying than doing things in real. So I looked on my Google Calendar which gives me all earnings announcements for stocks I have ever for whatever reason been interested in and as luck would have it there were two stocks that met my requirements with earnings next week: KR (which has weeklies) and JKS (which doesn't).

Now I hear you cry, What is JKS? Yeah - errm - its the largest Chinese solar company which I have traded options on in the past. Mind you those were straight out - very profitable - bull plays with just a bunch of humble calls. The great solar boom got clouded at some point and I lost interest in them though they still show up on my screens because of history. In my defense I have to say I don't have any record in my journal of liquidity issues - I trade conservative volumes- on my calls in 2014/2015/. Mind you I never traded the earnings then either.

Anyway - I set up the following trade on 28th of August:

sell 8 C SEP17 26 @ 1.00$
buy 8 C OCT17 26 @ 1.90$
sell 8 P SEP17 23 @ 1.10$
buy 8 P OCT17 23 @ 1.95$

Net debit: $1400+80$ commissions

The strikes were set taking into account implied volatility and SD with a margin of error and when I entered the trade there was certainly a bid/ask spread larger than on KR but nothing particularly shocking. I plunked in the middle prices and got filled relatively quickly. I admit I didn't check open interest... I projected what would happen in my options software and as long as volatility didn't plunge I wasn't risking much of a loss and possibly looked forward to a profit if volatility moved.

Now darnit - the day after I opened my trade the stock started trending strongly in fact since Monday 8/28 its up 16%. Volatility also increased despite the rise which means that I wasn't totally wrong however with such a change the very basis of what I was trying to compare was being undermined. Now I didn't panic - in fact at current volatility I am hypothetically still in profit even. Also hypothetically though the put side doesn't fulfil its function any-more so it should be closed out or moved up and maybe the call side too. I looked to intervene as of Tuesday near closing time - that's when I noticed bid-ask spreads had suddenly widened considerably. I put it down to the jump of the day, the fact its a Chinese stock trading in big volumes in Asia (so US closing time is really deep night for them) and just generally that.

Now before you rush to look at the closing prices and check the bid/ask spread - what your screens will show is NOTHING like what is quoted during the day. Yesterday the bid/ask on the OCT put at one point was 0.75/4.30 or something of that ilk. A trade flashed by of 1.10 but it never got quoted even though at that point I was trying all the time to get out of my position for prices reasonably close to theoretical values. I was doing all the logical things such as setting prices at reasonable levels compatible with the options pricing model (as calculated by my software) - I even went quite a bit beyond. Absolutely no joy - loads of volume appears offered but like I said the bid/ask spread is murder. I then did start checking open interest and realised that the options with the widest spreads were the ones that had open interest that amounted to anything. At the close bid/ask suddenly narrowed real fast but still beyond a reasonable trade - the SEP put stands at 0.35/0.75$.

Now I have the impression the MM wants to take me beyond earnings on Thursday and pound me with the volatility crush but maybe that's just me feeling victimised. Things is I have the ground moving under my feet on this trade and though adjustments are perfectly possible to correct the positions I cannot execute them when bid/ask spreads are where they are. I tried a bunch of things yesterday but execution is really not taking place.

So the question is what to do?

 

[tfp]

Congratulations - you just paid $1,400 in education fees to the university of thinly traded options. A few recommended steps:

• Realize you only have Tuesday Sept 5 to work with before earnings premarket on Wed Sept 6. There may not be much you can do before earnings.
  
  
• Constantly ask yourself - what's the worst thing that can happen?
  Your thesis was wrong - you expected it to stay delta neutral but instead it shot up.
  Where's it going? Seems like it's could rotate to the other side and hit 32+ and grab some legs once stops above 30 start panicking. You're short 8 Sept calls, which could get assigned - but that's not likely to happen until closer to Sept 15. Then you'd own 800 shares of JKS, but you'd also still have those Oct 26 calls to offset the damage.
  
  The trade has theoretically lost ~$500, your thesis was wrong, your job is to get out entirely while minimizing the damage. After earnings if she does go to 32+ you could lose another $500-$900 - that's the price of poker.
  
  Those puts are likely to expire worthless. If she does head to 32+, the put spread can lose another $300. If you can close it anywhere close to parity right now, it could break even. Put a closing calendar spread out there to try and sell it for $.85 and see if they nibble. You could even try $.75 or .80 and let it work to get out of the worthless Put side of the double cal spread and contain that part of the damage.
  
  While the closing put cal is at work in the market, you go back to focusing on the Call side. The Call side can lose another $200-300 as well. You paid $.90 for the Call calendar. Put a closing order out there and see if you can sell it for $.50. You may be hosed until after earnings when the volatility subsides, but your focus would be on avoiding the assignment if you don't want the shares.
  
  
• Try to contain your $1,400 loss to no more than $1,000 after earnings to get out before Sept 15 expiry. If somehow you manage to do so, you will have stopped further bleeding.
  
  
• You could try selling a Sept 27/28 Put spread for $.60 to contain the damage if she does go to 32+. However, this involves throwing more money after bad - which I don't necessarily believe in. But it might contain the damage if she breaches 32+ and does not drop below 22. It involves more capital and more risk - not things I'd recommend for you at this stage - just pointing out options.
  
  
• Don't panic. It should be easier to get out after earnings and you have time before Sept expiry. Your losses will be what they will be. There is a chance earnings suck and if she drops below 26 you'll be glad you didn't panic. I anticipate higher odds of this thing going to 32+, but hey, we'll see...
  
  
• Apply your 'tuition' to write down on a sheet of paper.
  Say it with me - I will never ever never open calendar spreads on stocks that do not have penny wide bid/ask spreads. Write it down 100 times and then read each line out loud.

Here is what I see on my end - we can see that weak shorts above 30 can fuel the run to 32 and beyond...

See how she rotated 4 handles below the consolidation range? She can now rotate at least another 4 handles above with stops of weak holders sitting at 30...

Here's the double cal you have on - you could be in for a joy ride:

I don't know if you can get this pricing on Tuesday - it's risky, but might contain the damage if weak shorts panic above 30:

I wish you well - PM me and we can chat further if you're not able to get out before earnings...

Disclaimer: thanks for pointing out the setup, I may take the other side

 

[Overnight]

...

Disclaimer: thanks for pointing out the setup, I may take the other side

Haha, ouchy, that's mean!

 

[TrustyJules]

@tfp First of all - a great thank you for taking the time to write the answer. It really is very kind of you and I found everything you said extremely helpful. In particular your outlook on where the stock is going is super-helpful . Just to start where I concur wholeheartedly:

• Tuesday is the big day - yep - I didn't see labour day coming because I am not American - duh is me!
• I have written down a 1000 times - I will not open double calendars on stocks with more than pennies spread. I would like to say its the first time liquidity burnt me but I now recall something not dissimilar with Thor Industries some years back. I really should know better!
• containing the loss - yes this is the plan - if I get out at 0 $ I shall consider it a major win and if its -500$ I have done well.
  
• dont panic - yes - thats key!

Now closing the spreads/opening a higher one with the ones I have left open - I didnt want to make my tale longer than it was but I tried that. I will try again on Tuesday as you suggest but I am gravely concerned I wont get filled. Honestly I have never seen a spread as brutal as what I was coping with Thursday/Friday (on Wednesday I was still lackadaisical) . I totally agree that normally I should be able to close the spreads for - at worst - small losses but I tried for hours on Friday and nothing worked.

There is one point I am perhaps misunderstanding you - you say I could get assigned on the calls and therefore be long 800 shares of JKS. Surely its the opposite? I sold SEP calls - I will be SHORT 800 shares of JKS. (Whilst still being long 8 calls OCT - alternatively my broker could simply exercise those). This makes your prediction - which really is extremely helpful - even more important. If it goes to 32$ well... ouch... In a double calendar with such a strong deviation the front month will cost you more than the back month will give you back. Furthermore volatility will go poof on Wednesday and my OCT options are going to lose value.

On where the stock is going - I think I have one hope - the 29$ resistance was bounced off 4 times before. It could be that the stock will reverse course but like you say, if the 30$ shorts panic the ride will be rough.

Now you made one point which really struck me: I should have asked myself what went wrong.

The delta went wrong!

Because the spread is so big we have to guess a little at the IV. I am thinking its at 50/100 for calls and puts respectively. That makes me about 200 delta short on the position - hence there seems to be a hedging solution that doesnt require me to trust the CBOE market if I cant filled. I could simply buy 200 shares and that would make me delta and vega neutral and therefore I can survive the earnings. It seems unlikely this kind of spread would last until SEP expiration but its possible. Admittedly I am throwing more capital at it and I am not sure what happens exactly on the put side after expiration. If we have a bad earnings result and a huge drop the puts may be shooting up again. This needs more analysis - however thank you for your pointer as it kick started me to think about the delta rather than the position.

 

[tfp]

You make some great points Jules. And yes you are correct - apologies - if assigned you would be short 800.

To @Overnight's point, the day one realizes that's not mean, but simply the way the market works - you are on your way to thinking like a market maker.

Jules - i wish you the very best next week. I share mostly because I've been there.

 

[TrustyJules]

Ok I have put Labour day to good use and modelled things as best I could. The big question is what happens to volatility if I am pushed beyond earnings without being able to close the trade. This has a non-negligible impact on the outcome, in fact if you choose very high volatilities for tomorrow then theoretical pricing says I might be able to exit with a profit. More conservative volatilities show that instead I am at -500$ to -200$ (based on closing prices I am only at -200$) so exiting at that sort of level is par for the course.

My goals are (in descending order of importance):

• Exit for a minimum loss;
• Make the position delta and vega neutral;
  
• Exit before earnings;
• Avoid risking too much capital;
• Exit with a profit.

Here's a few facts:

1. I am currently 200 delta short - unless there is a huge upward move over 32$ of the stock, that is more or less a stable number. The highest possible is about 400 delta short in case of an adverse move;
   
2. I am currently 40+ vega long - volatilities are high on 60/40% for the calls Sep/OCT respectively and 126/92 for the puts. Average historical volatility is 60% or so and I am presuming the OCT calls will fall to well below that after earnings. At a guess I will say we come out at 30/50 for the calls/puts - i.e. a potential 1000$ loss on the OCT options partially compensated by the SEP ones (but not enough).

Now I made some analysis of the stock and in particular how much it moves about in SDs:

Its scatter chart of the last year showing the moves of the stock from close to close calculated in SDs. This can be summarised in the following table:

Basically this stock is quite mobile but in vast majority the moves are below 3SD. Previous quarterly results show that it moves about 2 SDs. Depending on which IV you take that makes for a move between 1.80-3$ or close enough to that. Thats pretty coherent with tfps view that a run-up to 32$ is possible and I am adding that the downward risk could be guessed at being around 24.5-25.50$ or so. The chart - see previous post - to see that's a reasonable assumption. I am also assuming that if we go beyond earnings the bid/ask spread will normalise to nickels and dimes again.

So my problems are:

1. Extreme bid/ask spread - particularly on the options I already have;
2. Volatility crush that will hurt my long options if I go beyond earnings;
3. Position max. net loss maximum is currently ca. $1400.

So here is the plan in chronological order - so if one fails we try 2 etc..:

1. Start the day by trying to exit the spreads at reasonable prices - hypothetically this should be possible at a loss of no more than 0.25$ x 800 = 200$. Seeing my experience last week I am not holding much hope for this one.
2. Sell 6 or 7 P OCT17 26.00 for $2.50+ for a net credit of $1750 (this depends a bit on stock move tomorrow). This will have several effects: the position becomes delta and vega close to neutral again. Any price over 25.50$ at SEP expiration will yield a profit; at 24.50$ the position loss is still only 500$. After that it gets harder but I am banking it wont go there and the probabilities agree with me. This strategy would be great presuming the bid/ask spread on this option - which was acceptable Friday and for which there is little volume - doesn't widen tomorrow.
   
3. Buy 200 shares of JKS on the open market - this will make the position delta neutral (but not vega neutral). This basically locks in a loss at all prices of JKS >23 - below that it gets hairier. Problem is that the vega sensitivity has an impact and this could seriously harm the total bottom line. The advantage is that JKS is liquid on the stick market and this strategy can be executed regardless of MM shenanigans on the CBOE.

 

[TrustyJules]

As Napoleon said, no plan survives contact with the enemy. What helped was that the stock took a tumble from the start. After the loony half hour ended ,I started the day out by trying to close the spreads. As luck would have it the SEP short calls closed more or less at theoretical value. I should add that my broker is European and not so sophisticated so I have to input spreads by hand and cannot contract to close for a fixed fee.

Anyway, whilst closing one leg was good it left me with more vega exposure than before so it became imperative to close the long side as well. It was quoting something like 1.50/3.80, I walked it all the way down to 2.85 but no takers at all. The price is well below theoretical value and I wasn't budging more than that. Meanwhile I did see the opportunity to close the put spread for a 0.20$ profit.

My challenge remained the same - become delta/vega neutral. I gave up on closing the OCT 26 calls and instead looked up the option chain. The 27 calls traded at a reasonable price and I got filled real fast - it just shows that the MM was really sitting on those chains that had large open interest.

This solution has pros and cons. It limits the damage to maximum 800$ loss. If JKS sticks the probabilities and moves max. 2SD tomorrow the loss should be between 400-600$ which was pretty much my target. One other advantage is that even if the bid/ask spread doesnt narrow after tomorrow I can carry this to expiration until the options are quoted at intrinsic value. Finally I also recuperated half the capital from the trade and therefore protected my trading base. Now I can only wait for the earnings to come out. Its a good lesson that illiquidity is a real risk even for retail traders.

As a side remark - the bid/ask spread on MON just jumped as well, the C SEP17 116 is quoted at 0.15/3.30$. Obviously something is being expected!