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Trading the short calendar spread
- Thread starter Twinsen
- Start date
Future options have much lower margin requirements on these spreads.
there is a fundamental difference between calender spreads in futures as oppose to equities.. the risks are very different... as many times the options are on different contracts within the same instrument.. where as a stock option of any calender month is derived from just one place.. the stock..
Quote from cdcaveman:
there is a fundamental difference between calender spreads in futures as oppose to equities.. the risks are very different... as many times the options are on different contracts within the same instrument.. where as a stock option of any calender month is derived from just one place.. the stock..
I'm a bit confused here. If the criteria is having different contracts, then any FOP calendar spread would be margined as naked, ie no difference long or short calendar spread.
I wonder how calendar spreads on soy and wheat, for example, are margined given the seasonality of these commodities and the way price moves differently for the different contracts.
BTW, this is a very timely discussion. Closed a UNG calendar spread today but a big chunk of the profits was eaten up by commissions. Can't increase size with the ETFs, need to switch to FOP.
Quote from justrading:
I'm a bit confused here. If the criteria is having different contracts, then any FOP calendar spread would be margined as naked, ie no difference long or short calendar spread.
I wonder how calendar spreads on soy and wheat, for example, are margined given the seasonality of these commodities and the way price moves differently for the different contracts.
BTW, this is a very timely discussion. Closed a UNG calendar spread today but a big chunk of the profits was eaten up by commissions. Can't increase size with the ETFs, need to switch to FOP.
I'll try to clear things up. Futures markets that have different contracts are margined according to risk. Your broker has a margin schedule to follow for all the contracts. Equity options are treated as naked when the deferred month is sold and for good reason. You have unlimited loss potential. Not in terms of price, but in terms of vol! I could tell you stories of guys that got blown out on the floor by being long front month and short back month on some biotech stocks. The long option is basically flat or dropping and the back month is going through the roof. Not a big deal if you are well capitalized, but if you are heavily margined, it will blow you out.
And of course the very situations in which guys like to sell back month options are precisely in those situations whether it be earnings, FDA news, court verdicts, etc. If anything, I think the margin is too loose by simply applying the deferred option as naked. That's basically a haircut of only 20%. That's nothing on a biotech stock.
Quote from Maverick74:
I'll try to clear things up. Futures markets that have different contracts are margined according to risk. Your broker has a margin schedule to follow for all the contracts. Equity options are treated as naked when the deferred month is sold and for good reason. You have unlimited loss potential. Not in terms of price, but in terms of vol! I could tell you stories of guys that got blown out on the floor by being long front month and short back month on some biotech stocks. The long option is basically flat or dropping and the back month is going through the roof. Not a big deal if you are well capitalized, but if you are heavily margined, it will blow you out.
And of course the very situations in which guys like to sell back month options are precisely in those situations whether it be earnings, FDA news, court verdicts, etc. If anything, I think the margin is too loose by simply applying the deferred option as naked. That's basically a haircut of only 20%. That's nothing on a biotech stock.
Thank you for the explanation and sharing your experience. One question though: my impression was that, so long as the underlying is the same and the front month has not expired, you are in fact hedged. For example, if you are short a call calendar and the back month implied vol explodes, you can always exercise the front month to convert the position to a covered call and ride it out (assuming that the stock price doesn't subsequently collapse before the back month expires). I can see that you could face substantial mark-to-market losses depending on position size, and you would need to have enough cash to purchase the shares. So if you have a hugely margined position with a lot of short calendars on, you wouldn't be able to survive long enough to ride it out. It is not that the short calendar is not hedged up until the front month expires, it is that it takes available margin to salvage oneself in a situation like you described, so if you have too many on you are sunk needlessly because you can't ride out the storm due to your leverage. Same basic problem I suppose that LTCM had. Am I thinking about this correctly?
A pm account will provide much better relief. But Mav is right. A short calendar is an unlimited risk position.
Quote from noregrets:
Thank you for the explanation and sharing your experience. One question though: my impression was that, so long as the underlying is the same and the front month has not expired, you are in fact hedged. For example, if you are short a call calendar and the back month implied vol explodes, you can always exercise the front month to convert the position to a covered call and ride it out (assuming that the stock price doesn't subsequently collapse before the back month expires). I can see that you could face substantial mark-to-market losses depending on position size, and you would need to have enough cash to purchase the shares. So if you have a hugely margined position with a lot of short calendars on, you wouldn't be able to survive long enough to ride it out. It is not that the short calendar is not hedged up until the front month expires, it is that it takes available margin to salvage oneself in a situation like you described, so if you have too many on you are sunk needlessly because you can't ride out the storm due to your leverage. Same basic problem I suppose that LTCM had. Am I thinking about this correctly?
OK, so let's walk through this. Say you put on a calendar spread in Aug/Sept at the 100 strike in XYZ which is trading at a 100. You sell the spread for 2.00. You want the broker to ask you how much in margin? Right now you will put up 2k for this trade to sell the spread and $200 to buy the spread. Let's be nice and say this broker only asks for $400. Say you put the spread on 10 times for 4k in margin. Say some news comes out that on Sept 10th a critical verdict will come out on a court case that will decide if this company will stay in business or not. So the back month 100 strike call and put both shot up in value from say 4.00 to 40.00. The front month call and put didn't change, let's say it's 2.00. Your spread you sold for 2.00 is now 38 pts against you or 38k. Let's say you had 45k in your account, plenty of cash for the 4k in margin your broker was asking for. But now your equity is down to 7k. What is your risk? You say you are hedged? Hedged against what? The stock is not going to move until sept 10th, then it will either explode up or possibly go to zero. Your long call "your hedge" expires on say Aug 21st. You say no problem mr. broker, I'll buy the stock. You will? You will buy 1k shares at $100 per share? That's 50k in margin, you only have 7k in your account. And if for some reason you did buy the 1k shares of stock do you know what your risk is? It's not to the upside, it's to the downside. If the stock goes to zero, OK, you make back the loss on the short Sept call as they go out worthless. But the long stock at 100 goes to zero and you are out 100k. You made back 40k from the short calls leaving you with a 60k loss. Your account only had 45k in it to start with.
This is why the margin is not going to be $200 as is the case with the long spread or even $400. Even with the margin they are asking of 20% or 20k, it's not even enough. That's why I said initially the margin should be even higher then the standard 20%. And what makes this worse is, most guys who do these trades are not putting them on when vol is cheap, they are putting them on precisely to try to exploit that back month vol which is usually high for a reason! The market is telling you it's going to make a large move during that time period. Not when you have your long call on. So either you get forced into a margin call when the spread blows out to 40 pts or you say F*ck it, I'll take my chances and exercise the stock and gamble on a non event news item. Either way, short calendar spreads are NOT hedged trades. Not even remotely close to hedged. In fact, you are specifically making a binary trade on an explosive outcome in which you have no control over and no ability to do anything after such event occurs. Hopefully, I've explained to you the dangers of this trade.
The margin should always be less than the 20percent (rulenofnthimb for naked options) as you have some hedge. The calendar is better than the outright short.