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Let’s look at what we can do with a Calendar Spread after expiration of the first short month, and try to eliminate as much risk as possible as the trade progresses.

The screen shot and chart below (Figure 1) is the trade at inception. The stock is GD, a June/August 2007 $80 Put Calendar Spread, entered on May 1st, 2007. The bid/ask spread has been shaved, and the return on investment is over 100%. IV is low and the stock is currently in a gentle uptrend, though it has shown some resistance at about the $81 mark. I have kept the total trade cost as close to $1000 as possible. The calendar is slightly bullish. Notice the positive delta of 68.17, rather than a neutral delta. Thus my view is that the stock may increase further over the next 30 days.

Figure 1: GD Calendar Spread at inception

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In the screen shot and chart below (figure 2), the trade has only four days to go. Gamma has become much larger than Theta. This is possibly too much of a risk, as a directional move either way means that the trade stands to lose a lot of its profit. We have made 63% on our risk, so let’s look at a way of remaining in the trade, whilst further decreasing our risk.

Figure 2: GD Calendar Spread - 4 days till expiration 

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When assessing the current position of the trade it’s easy to think that we still have a risk of only $990. This is incorrect, as we have just made $630 profit (though yet to be realised.) Should the trade turn against us tomorrow, we could lose our profit of $630, plus the original risk of $990, a total potential loss of $1620. It’s not that we’re in a riskier trade, but there’s more money now we could give back to the market. If we closed the trade here on June 11th, four days to expiration, we would take $630 profit (without shaving) or 63%. If we simply rolled the trade, bought back the 9x June 80 Puts (grey), and sold 9x July 80 Puts (green), our position would look like this:

Figure 3: GD Calendar Spread – Rolled into July

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Notice these figures on the screen shot and chart above (figure 3).

It’s important to note from this risk graph that whilst the numbers are all green and the trade is risk free, risk still exists in the trade. Where? Remember that we could potentially lose the profit we have just made. If the trade went against us, we would lose nearly all the profit, and only take home $90. Keeping this in mind, let’s have a look at how to take more profit off the table while still leaving room to make more money.

One way to do this is to offload some of our long August options, since the August 80 Puts are currently trading for approximately $2.50 each, but the July options are only trading for approx $1.85. The difference here is 65 cents, or $65 per contract. So for every long August option that we offload, we bring in $65 more than we would have if we had kept it and sold a July against it. Remember this is only a nine contract trade, so if we sell off one of the August options, we only have eight left to sell against this –meaning we could only then sell eight July options.

The downside to this move is that you are effectively decreasing your ability to make more money in the long run. For example, if the long option was November, then every long November we offload is one we can’t sell against each month for the next few months – less income potential for the rest of the trade, but more risk removed and therefore more guaranteed profit. In this situation, there is no ideal number of contracts to sell. There is a compromise that you, the trader, need to make in order to find a balance between the level of risk that you are prepared to still take, the level of potential profit left in the trade, and the amount of profit you want to lock in. Some of us will be prepared to risk a little more than others, so keep in mind that this is an individual trading decision. The adjustment and ratio I have chosen is to sell off 6 August contracts and therefore sell only 3 July contracts (figure 4).

Figure 4: GD Calendar Spread – After the adjustment

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If everything went wrong in this trade, we would still make approx 48% on our original risk ($480 min profit from originally risking $990), even if it took two months. One might think that 48% is great for one month, but not over two months. The fact is we’re not leaving our capital tied up for that second month. When we took the risk out of the trade, what we actually did was bring our original $990 of capital back out of the market, which leaves it free to be put into another trade. Perhaps put some price alerts on at around the $77 and $84 mark, so if the stock moved to these levels, we could close the trade for a profit. Now our Calendar trade is a ‘set and forget’ – Sit back and let Theta do its thing!

Manage Your Risk!

Matt Baker
Trading Tutors Team

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