In another month of fast-moving, trending price action—one of the two worst scenarios for the Calendar Options strategy (the other being a plunge in implied volatility)—we were able to come away with only a small average loss. We played it cautiously from the beginning, expecting the resumption of the bear market to keep price volatility high throughout the cycle. Consequently, we entered just two trades for July.

We had to make one adjustment by the time July rolled around, but both of our positions remained quite manageable—until the latest chapter in the credit crisis story hit. As fears of a banking meltdown grew, we made risk management our number one priority and closed both positions. Even though our two trades averaged a loss of 1.71%, we managed to beat the S&P 500 once again.

Performance comparison

Market performance for the past month:

• S&P 500: −4.47%
• Dow Jones Industrials: 0.38%
• Russell 2000: −4.71%
• S&P Covered Call Fund: −8.26%
• Calendar Options: −1.71%
  Note: The time period measured is from expiration to expiration.

July Calendar Spreads

• EEM July/Sept 140 Calendar Spread: −9.42% return – We opened this position once it looked like EEM had found support around $138, where it had consolidated in April on its way up. Two days later, the ETF broke down, closing off $4.63—more than twice EEM’s one-day standard deviation. We were able to keep pace with the sell-off by making two adjustments, and in a “normal” month, we would’ve kept this trade going into expiration week and rolled our short options out to the following month. But as the Friday before expiration week unfolded, it looked like one of two things would happen Monday morning: Either concerns over Fannie, Freddie, and Indy would drag the market into the abyss, or a government bailout would cause a sharp rebound. With expiration-week gamma risk looming, the only reasonable play was to punt.
• IYR July/Aug 61 Calendar Spread: 6% return – Part of our thesis when we entered this trade was that although ongoing worries about the economy probably would pull IYR down with the overall market, the real-estate bubble had burst long ago, and there was little likelihood of any more surprises particular to this sector. Then investors woke up to the fact that if Fannie Mae and Freddie Mac were to become insolvent, credit might lock up so tight that real estate transactions, not to mention new development, could come to a screeching halt. We held on through one adjustment and the subsequent whipsaw, but you don’t ride a calendar spread into expiration week on the heels of two 3.5-σ days. Sound risk management dictated that we close the position immediately.

July Reading

We published only one general, strategy-oriented Calendar Options post during the July cycle, but it’s one that any trader who wants to learn the strategy should read:

• Adjustments, Part III — How We Adjust

Another, older post we recommend reading (or rereading) in conjunction with this Monthly Review is our explanation of How We Calculate Returns. Because we adjust our trades, and adjustments often involve rolling a fraction of our position, it’s not intuitively obvious how, for example, we could have opened our July IYR calendar spread for a net debit of $1.15 per share and closed it for a net credit of $1.325 per share, yet have a profit of only 6%, as shown in the Calendar Options table on our Performance page. Understanding the actual performance of the strategy is another must for anyone interested in following Calendar Options.

Looking Ahead

Implied volatilities are still running higher than we like for buying calendar spreads, and it’s already less than 25 days to August expiration. Under the circumstances, we might not get a good chance to enter a Calendar Options position this month. We can’t realize the returns that probability predicts for our strategy over the long-run if we let last month’s volatility and losses prevent us from trading the next month, and the next, and the next—but that’s not what we’re doing. In this case, we’re merely exercising discipline by following the rules of our strategy, which dictate that we enter a trade only when the implied volatility of the options is decidedly below the middle of its 12-month range. Despite the fact that the VIX has dropped more than 30% since its July 15 peak, the options on our Calendar Options short-list are still overpriced.

When risk is running high, it’s important to remember that missed opportunities are easier to make up than losses on bad trades.

The theme for July was most certainly risk management.  The broad-based decline this summer has been quite breathtaking to watch, especially as all of the technical and sentiment-based indicators that we follow moved from oversold status to extremely oversold status to something like doubleplusungood.  Our attitude throughout late June and early July was that the unending litany of bad news deserved to be taken seriously, and that waiting around for the “inevitable bounce” and “inevitable VIX spike” would be a fool’s errand.

As a result of this warranted concern, we only published two newsletter positions for July, and we exited those two positions a bit on the early side in order to preserve capital and shift our risk into August.  By taking advantage of the brief rally on July 8, we were able to exit the put spreads of those trades for very small net debits.  While a few members were understandably disappointed about voluntarily taking some small hits with two weeks to expiration, we were plenty happy to dodge the expiration week SEC-inspired shenanigans.  Holding out for monster rallies and oversold bounces is a dangerous game, and over the long run, evidence-based trading beats faith-based trading every time.

Performance Comparison

Here’s how the major market indexes, the S&P 500 Covered Call Fund (BEP), and the Condor Options trades performed over the past month:

• S&P 500: -4.47%
• Dow Jones Industrials: 0.38%
• Russell 2000: -4.71%
• S&P 500 Covered Call Fund: -8.26%
• Condor Options: -8.45%
• Note: the period measured is from expiration to expiration, rather than from the start of the month.

Given the leverage inherent in options trades, it is to be expected that any options-only strategy will have a higher standard deviation than the equity indexes, outperforming the indexes by a wide margin during good months, and underperforming by a wide margin in bad months.  And given that tendency, it is encouraging that our index positions only slightly trailed the market averages, and were just a hair behind the S&P 500 Covered Call Fund (BEP), our chosen benchmark.

One other important point here is that we intentionally kept our powder dry through July: we typically open about 3 newsletter trades per expiration cycle, and if we factor in that third “cash” position, our average return per trade for July was a not-unreasonable (and BEP-beating) -5.63%.

We are traveling back to New York today, and will have to skip this month’s individual trade review and monthly reading sections.

We understand why retirees and families and everyone but our hipster friends flee the city in the summer.  Conservatives have been accusing the fantastic WALL·E of being some kind of dystopian humorless lecture for its portrayal of a dirty, dehumanized urban wasteland.  But if they think that Pixar is trying to scare us with some unlikely view of the future, rather than simply extrapolating from the present, then they haven’t been to Times Square in July.

The first month of Calendar Options trading was characterized by the high day-to-day price volatility typical of market transitions. As the late-March to mid-May bear-market rally came to an end, we were buffeted in the buying climax and the sharp selling that followed—but we still came out with an average profit of 6.59%, handily beating the market. (If you’re wondering how we come up with our dollar return and percent return figures, see Calendar Options: How We Calculate Returns.)

Performance comparison

Market performance for the past month:

• S&P 500: −7.54%
• Dow Jones Industrials: −8.81%
• Russell 2000: −2.09%
• S&P Covered Call Fund: −5.62%
• Calendar Options: 6.59%
  Note: The time period measured is from expiration to expiration.

June Calendar Spreads

• EEM June/Sept 140/150 Double-Calendar: 16.72% return – No sooner had we opened this trade than EEM took off on a 5% rally over four days, forcing an adjustment. The following Monday brought a dramatic reversal, and three weeks later EEM was nearly 10% off its climax high, when we had to unwind the first adjustment. A relief rally brought the position back to our 15% minimum profit target Monday before expiration.
• RTH June/July 95/100 Double-Calendar: –4.23% return – We opened with RTH in the middle of what looked like a developing trading range. We were right about the trading range, but two adjustments were triggered, by a false breakdown and then a false breakout. With our position on the ropes, we made a third adjustment to up our odds of recovering our loss. On Monday before expiration, we were able to close nearly all of our position for a 1.41% loss; but to get the remainder filled we had to lower our limit price later in the day, for a 7.04% loss. The –4.23% return above is the average of our two fills.
• IBM June/July 125 Calendar Spread: 7.28% return – IBM had its share of volatile swings as well. A sharp two-day rally, culminating in a breakout, triggered a first adjustment, and after a reversal and two 2+ standard-deviation down days, we needed to reduce our risk by adjusting again. With the market looking shaky and our gamma risk growing, we closed the position four days before expiration for a modest profit.

June Reading

Anyone interested in following the Calendar Options strategy should be sure not to miss these key posts:

• Introducing Calendar Options
• Calendar Options: Five Things You Need to Know About Calendar Spreads
• Calendar Options: Puts or Calls?
• We Get Letters: Calendar Options Position Sizing
• Adjustments, Part I – Why We Adjust
• Adjustments, Part II – When We Adjust
• Calendar Options: How We Calculate Returns
• Adjustments, Part III – How We Adjust

We opened one July calendar spread, on EEM, last week. Even though EEM lost $4.63 on Friday—twice the one-day standard deviation—we’re already showing a small (1.15%) profit. We plan to enter another position this week if volatility stays near its Friday range, or drops significantly.

We feel like we’re saying this every month, but it sure feels nice not to have any skin in the game come expiration day.  Options expiration surely had something to do with the intensity of today’s selloff, and this was a textbook case of why we never hold positions into expiration.

The fancy-pants phrase for the influence options expiration had today is “negative gamma.”  The practical significance of that phrase is that when we gapped down at the open, lots of traders who were short options that they assumed were going to expire worthless were suddenly holding contracts that were now at or in the money.  They have to take action to deal with the situation, and all that covering and hedging of those shorts only adds fuel to the fire.

We got a long, low-volume midday pause, but then the selloff resumed after lunch.  You know there were some unfortunate souls still holding short puts at SPX 1320 or SPY 132 who were sweating into their turkey sandwiches, hoping we would bounce or tread water into the close.  Sorry, guys.

Keep reading for more performance data and trade analysis… Read the rest of this entry »

We’re making some changes to our monthly review - hopefully the structure of this new format will make it easier to follow along and compare our strategy with the relevant benchmarks. Going forward, we’ll include the following items in each monthly review: 1) a quick-glance overview of our monthly performance, in the chart at right; 2) a performance comparison of our positions for the month vs. the SPX, DJIA, and RUT, plus BEP, which is an S&P 500 Covered Call Fund. 3) more details about each of our positions, including any comments we may have; 4) links to important (non-trade) articles from the past month, in case you missed any of them.

Performance comparison

Here’s how the major market indexes, the S&P 500 Covered Call Fund (BEP), and the Condor Options trades performed over the past month:

• S&P 500: 2.52%
• Dow Jones Industrials: 1.07%
• Russell 2000: 2.78%
• S&P Covered Call Fund: 7.69%
• Condor Options: 12.62%
• Note: the period measured is from expiration to expiration, rather than from the start of the month.

May Iron Condors

• DIA 116/118/134/136: 30.46% return - This was a no-brainer; we closed out the 188 puts on principle (markets tend to crash down, not up) and let the rest expire worthless.
• DIA 113/115/130/132: (10.56%) return - We closed out this position fairly quickly as the rally gathered steam in order to reduce our overall risk. As part of a larger portfolio, it would have been easier to hold on and make an exit several days later for a small win/breakeven - some readers did just that.
• SPY 128/130/146/148: 17.96% return

May Reading

Here are some posts from the past month that are worth checking out if you didn’t catch them the first time around:

• Getting Your Fill
• Calendar Options: Five Things You Need to Know About Calendar Spreads
• Introducing Calendar Options
• How Vega Can Deceive You: Part I
• How Vega Can Deceive You: Part II
• 8 Hedging Ideas for Iron Condors, Part 1
• 8 Hedging Ideas for Iron Condors, Part 2 (Members only)

We’re already in two June positions and, if implied volatility picks up next week, may well enter two more. Hopefully this summer will be a bit more lively than usual!