Low Risk/High Reward (60%+ per Year) Calendar Spread

Quote from jones247:

Hi Thinkplus,

I chose a long term spread (i.e. Dec/Jan) because of the option price convergence between the two months.
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I am actually testing this method, not just discussing it.
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I am not sure which quotes you are referring to, and may be I am not clear about your objective, but let's consider the basic premise of the strategy.

Calendar (and the related) spread strategy is a neutral strategy, that is expecting the underlying to remain in a range while we benefit from the time decay of the sold premium. Basically, you want higher theta while keeping the other Greeks pretty neutral.

Now you might be aware that option theta decays the most in the last 30 days or so. That means you want to sell the time premium which will decay faster than the one you have bought.

In your scenario, you are selling the spread for 6 and 7 months out. You will not see the immediate impact of time decay until the last 1-2 months (considering the underlying remains range bound), but you are planning to roll your spread by then, missing the whole point of the spread.

You can try out this in any options software (TOS or Optionsoracle), and see that spread theta is higher for near months (1-2, or 1-3) than for the farther months (6-7). You may have 6 month spread (buy 6 month /sell 1 or 2 month option) and continue rolling the short option (there will be higher delta/vega risk compared to having 2-3 month calendar).

You may use TOS thinkback feature to carry out your tests faster. Let us know your test results.
 
Walt,
with your strategy, which greek is your driver. Whenever I look at a new idea (for me), or chose an option strategy for a certain situation I think in terms of:
Which greek is driving this strategy?

So I am curious which is your driver.

SP
 
Hi Walt,

Quote from jones247:

It's entering into long term calendar strangle spreads with stocks having low IV. For example, I would buy a Jan 09 call ATM & sell a Dec 08 call ATM. Also, I would buy a Jan09 put ATM & sell a Dec 08 put ATM.
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Did you mean to say you'd buy the call and put calendars slightly OTM instead of ATM? From reading all the replies it seems you're doing a double calendar? Because selling both calls and puts ATM is really the same thing (a calendar).

Next month I would enter into another set of long term calendar strangle spreads for Feb/Jan. I would continue to do this each month. I would liquidate the initial (Jan/Dec) spread about the October/November time period. At that point I would begin liquidating and rolling/compounding each month. Based upon the favorable Theta (a definite certainty) & Vega (a probable situation if selected wisely) outcomes, I would yield about 20% - 40% ROI every month after the initial 3 - 4 month incubation period.
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May I ask your reason for rolling?
Just some thoughts I had.

1) How do you hedge your deltas when the underlying stock moves hard one way or the other?

2) When rolling, it's vital that the back month you're buying is still at historically low IV levels for your strategy to work. How can you ensure this at the time you want to roll? This is not predicatable.

3) As others have mentioned, if you want to capture theta, by selling the front month so far out, time decay is really really slow compared to the amount of margins you need to put up. It doesn't really accelerate that much till roughly the last week before the options expire. Even 3 weeks before expiry, it's still very slow! (to me)
 
Quote from jones247:

Your point on vega impact is well taken; however, I'm afraid of losing my delta neutrality, although I can hedge it against buying/selling the underlying.
Walt
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If you're going to handle delta hedging by buying/selling the underlying, have you considered the impact of the need for increased margins for doing this? There is very little leverage if you need to use stock (as opposed to futures) so you'll need to put up a lot of margins.

You'll need to set aside these margins from the start of the trade, and your ROI will no longer what you envisioned it to be.

Also what's your plan for tackling whipsaws?
 
Quote from Snowpro:

Walt,
with your strategy, which greek is your driver. Whenever I look at a new idea (for me), or chose an option strategy for a certain situation I think in terms of:
Which greek is driving this strategy?

So I am curious which is your driver.

SP
More...

Theta & Vega are the primary drivers of this strategy...
 
Hi hlpsg,

Points taken... I will report out on my results... I believe the key to mitigating major movements in the price of the underlying asset is to hedge with the underlying, although this would certainly reduce the ROI...

Quote from hlpsg:

Hi Walt,



Did you mean to say you'd buy the call and put calendars slightly OTM instead of ATM? From reading all the replies it seems you're doing a double calendar? Because selling both calls and puts ATM is really the same thing (a calendar).



May I ask your reason for rolling?
Just some thoughts I had.

1) How do you hedge your deltas when the underlying stock moves hard one way or the other?

2) When rolling, it's vital that the back month you're buying is still at historically low IV levels for your strategy to work. How can you ensure this at the time you want to roll? This is not predicatable.

3) As others have mentioned, if you want to capture theta, by selling the front month so far out, time decay is really really slow compared to the amount of margins you need to put up. It doesn't really accelerate that much till roughly the last week before the options expire. Even 3 weeks before expiry, it's still very slow! (to me)
More...
 
Walt,
OK with Theta and Vega as drivers, your biggest risk this far out is Delta (underlying directional movement). So to pick your best strategy you may want to look @ Standard Deviation probabilities in the dates you are looking to make your rolls. TOS analysis tab makes this exercise pretty easy to do.

It seems to me, if you are successful in this back to back 5-6 month calendar, you would want the stock to be range bound. However, I would think if the underlying was range bound the profit would be greater if you were rolling standard 2 to 3 month calendars. i.e. Aug/Oct or Aug/Nov rather than Dec/Jan. And looking for issues with relatively low Volatility or volatility skews in which you do an IV crush test. Then you would have a better edge with Theta decay, and you would still benefit from Vol rush.

I do your proposed type of trades often, and while it is nice having theta on my side. I am purely playing Vega, and buying the calendar at a price that is not severely impacted by strong moves in the underlying.

Lastly, I will be interested in hearing of your results, and the conditions at which you would stop yourself out of the trade.

Be great.
 
Quote from jones247:

Hi hlpsg,

Points taken... I will report out on my results... I believe the key to mitigating major movements in the price of the underlying asset is to hedge with the underlying, although this would certainly reduce the ROI...
More...

Walt,
I think the ROI is the least of your concerns at this point. You can worry about fixing that later if this strategy works out.

Firstly, to hedge with the underlying, you need to have a strategy for mitigating whipsaws. That, IMHO, is going to be your #1 problem.

For e.g. if you decide to short the underlying stock if it moves below $100. When do you decide to buy it back, should the underlying move back up?

How many times can you afford to do this, before you cry uncle and give up? Every time you get whipsawed, you're going to lose money in:
- the difference between your trigger point and the buyback point
- slippage
- commissions

These whipsaws will really eat up your option premiums (at expiry) real fast.

And if you decide to give up at a certain point after getting whipsawed to death, you're going to suffer losses from:
- the deltas against your double calendar position
- the losses from trying to hedge deltas by hedging with the underlying stock

Then you have to plan for gaps. If the underlying gaps below the point where you're supposed to go short, or gaps above your buyback point, what's your plan?

So you need a plan beforehand and you need to backtest it using reasonably accurate and precise data to see what kind of whipsaws you're going to be reasonably facing in real time.

The second major problem you face is rolling. When you decide to roll your calendars out to further months, you need back month IVs to be near historical lows.

What's your plan when you cannot get this? Do you just close out the entire trade and look for another stock?

If so, then why not just do double calendars using the options closest to expiry, with the back month IVs near historical lows? If you do that, then you benefit from both Vega and maximum Theta.
 
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