Cash-Settled Calendar Spreads -- Is Max Loss Actually Greater than Debit Paid?

[dragonman]

Hi,

It is known that generally the maximum loss of a calendar spread is the debit paid. Nonetheless, I think this is not true regarding calendar spreads on cash-settled index options such as the SPX, in which one can lose much more than the debit paid.

For example, if I buy 1150 SPX Oct/Nov call calendar spread for 14.1 debit, and if the SPX October settlement value will be at 1200, I will be assigned on my short October call and incur a debit of 50, and if the SPX November settelement value will be at 1150 (or lower), my long SPX 1150 call will be worthless and therefore my loss for the entire spread will be 64.1 (14.1 debit initially paid plus 50 debit due to the assignment).

However, such situation can never occur regarding physical delivery options such as the SPY, since whenever I am assigned on my short calls I can exercise my long calls.

Am I missing something here? If not, why are traders willing to trade calendar spreads with cash-settled options and therefore pose themselves to virtually unlimited risk?

 

[rmorse]

Because you can close down the second leg or roll the position at any time.

 

[dragonman]

Quote from rmorse:

Because you can close down the second leg or roll the position at any time.

This is correct if you assume that the wide bid/ask spread that you face while trying to close or roll the position (which are very wide on index options such as the SPX) will not just further increase your initial debit and also that you have enough liquidity to close the position (i.e., that you trade mostly ATM short term options and not OTM long term options, for example).

To me these assumptions look very dangerous regarding a trade which could result in unlimited losses if such assumptions turn out to be incorrect, unless there is something here that I do not fully understand.

 

[newguy05]

Quote from dragonman:

Hi,

It is known that generally the maximum loss of a calendar spread is the debit paid. Nonetheless, I think this is not true regarding calendar spreads on cash-settled index options such as the SPX, in which one can lose much more than the debit paid.

For example, if I buy 1150 SPX Oct/Nov call calendar spread for 14.1 debit, and if the SPX October settlement value will be at 1200, I will be assigned on my short October call and incur a debit of 50, and if the SPX November settelement value will be at 1150 (or lower), my long SPX 1150 call will be worthless and therefore my loss for the entire spread will be 64.1 (14.1 debit initially paid plus 50 debit due to the assignment).

However, such situation can never occur regarding physical delivery options such as the SPY, since whenever I am assigned on my short calls I can exercise my long calls.

Am I missing something here? If not, why are traders willing to trade calendar spreads with cash-settled options and therefore pose themselves to virtually unlimited risk?

your calendar spread ended at oct expiration, afterwards you are just holding long nov calls..

if spx goes to 3000 at oct expiration, and you close the spread at that time, your max loss is debt paid + commission/bid ask slippage

 

[rmorse]

Quote from newguy05:

your calendar spread ended at oct expiration, afterwards you are just holding long nov calls..

if spx goes to 3000 at oct expiration, and you close the spread at that time, your max loss is debt paid + commission/bid ask slippage

What if the market has a big rally and the long call is 75.00 at the expiration of the earlier call. Then the position is at risk for the $75.00 after the hedge is assigned with cash.

 

[dragonman]

"your calendar spread ended at oct expiration, afterwards you are just holding long nov calls.."

It's fine that the calendar spread in its original form ended at Oct expiration, but if you did not close your short leg prior to expiration than you will see at your account a "nice" debit of 50 (times 100 for one lot), and if you cannot close your long Nov calls for at least 50 then your loss of the position will be greater than the debit initially paid.

"if spx goes to 3000 at oct expiration, and you close the spread at that time, your max loss is debt paid + commission/bid ask slippage"

As I wroted to rmorse, it is a big "if", since the bid/ask slippage can be very large, some of the options are not so liquid and you may also not get a fill at the price you want, so again you may end up with a loss greater than the initial debit.

btw -- I will be very happy if someone who reads this post tells me that I am completely wrong, since I really want to trade SPX calendars and not only SPY's while knowing that my max loss is the debit paid.

 

[rmorse]

Quote from dragonman:

"your calendar spread ended at oct expiration, afterwards you are just holding long nov calls.."

It's fine that the calendar spread in its original form ended at Oct expiration, but if you did not close your short leg prior to expiration than you will see at your account a "nice" debit of 50 (times 100 for one lot), and if you cannot close your long Nov calls for at least 50 then your loss of the position will be greater than the debit initially paid.

"if spx goes to 3000 at oct expiration, and you close the spread at that time, your max loss is debt paid + commission/bid ask slippage"

As I wroted to rmorse, it is a big "if", since the bid/ask slippage can be very large, some of the options are not so liquid and you may also not get a fill at the price you want, so again you may end up with a loss greater than the initial debit.

btw -- I will be very happy if someone who reads this post tells me that I am completely wrong, since I really want to trade SPX calendars and not only SPY's while knowing that my max loss is the debit paid.

I agreed with you. If you're looking to close down or roll the spread using the complex order book, you will have to give something to the market makers for them to play. If this is your concern, stick with SPY or IWM where the markets are very tight but you loose that tax advantage.