My Rules for Calendar Trades

Written on June 18, 2008 by OptionsRopeaDope

These are not the best rules in the rules, and are getting tweaked constantly (especially defense). I’m going to split these into the three phases of the trade and the way I view them. Offense, Defense, and Endgame.

Offense

Offense is identifying an opportunity and opening a trade. The main purpose of these rules are to open a trade that has a better than average chance of being profitable. Or, being positioned so well that an *anticipated* adjustment will not negatively affect the overall profit potential of the trade too much. Good offense, or trade open, will put you in a great position to adjust as needed and prevent losses.

• 28-35 days out
• Start with single calendar, if at all possible, at the ATM strike
• Underlying over 80 (makes adjustments much easier)
• Underlying trading in a defined, predictable channel
• IV normally around 30 or lower 
• IV should be in lower third of range of IV values for the previous year
• IV Skew (front month - back month) should be > -2
• Favor ETFs over individual equities
• Research and plan for possible news or earnings or merger events that would affect underlying
• Make sure back month has same strike coverage as front month… otherwise adjustments will be impossible
• If choice of back months, choose farthest month where all rules (esp skew) are met
• Do not play during earnings months - IV increase due to earnings is a sucker’s play.

Defense

In his excellent book Financial Freedom Through Electronic Day Trading Van Tharp states that identifying and initiating a good trade is only 10% of the success of the trade. I think most income option traders, given the focus of information out there, probably think it is 90% of the game. The other 90% of the outcome is, in fact, dependent on managing the risk by adjusting or closing as necessary to keep the odds of preventing a loss in your favor. The purpose of defense is to obsessively prevent and minimize losses, not to maximize profit.

Adjustment points:

• Single
• If profitable, and the “today” risk curve breakeven is at or past the midpoint between current and next strike, move half of spreads to next strike
• At the very worst, adjust at expiration break even, or at 10% loss. Buy and Sell at the market if you have to.
• Doubles
• If profitable, and ”today” risk curve breakeven is at or past a strike, move half of “far” strike spreads to strike on other side of of the spread nearest breakeven (or, in a 1 - 2 - 1 “circus tent” configuration)
• Always adjust as above if underlying moves to halfway between expiration breakeven and nearest strike (do NOT wait until underlying hits expiration break even.) 
• Triples
• Assess trade - if profitable, consider shutting down w/o adjustment if underlying touches an outside strike. 
• When underlying hits outside strike, sell all far spreads and move to current spot spread (converting to a double), or next farther down.

Endgame

Endgame is when to bail out. Hopefully a fun time.

• Profit target - Singles = 20%, Doubles = 15%, Triples = 10%
• If desired, keep half of spreads in to reach for more profit, but always remove at least half at aboves targets
• Max Loss - Singles = -25%, Doubles and Triples = -20%
• If up 10%+, new max loss is breakeven
• Exit Friday before expiration if profitable - gamma increases risk a great deal during exp week, and risk graph starts to play tricks
• Consider exiting if profitable before major events (earnings, announcements) are scheduled to happen
• Consider exiting if profitable before adjusting to a triple calendar.

And a note on the end game - the single biggest reason why calendar trades turn into losers is waiting too long to make an adjustment. Also, if there seems to be a string of calendar trades ending at max loss, reevalutae your adjustments… with practice and experience, a calendar should hardly ever reach max loss…

Lastly, always diversify by putting on several calendars across different underlyings. Nothing will ruin your month more than putting all your eggs in one basket and getting a max loss.

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Posted in Trading Rules, Calendars