Yesterday we were blindsided by an explosive end-of-day rally in IYR. The gain for the day was a whopping $4.21–that’s more than 3½ times IYR’s  one-day standard deviation (which means the statistical probability of such a huge one-day move is less than 0.02%). Short-covering probably was a big factor in the size and speed of the rally…but regardless of the whys and wherefores, the market erased a week and a half’s losses in a matter of hours.

IYR has lost some ground this morning, taking the heat off our adjusted position for now. Yes, if we hadn’t made yesterday’s adjustment, we’d be in great shape right now–but over the long-term, we can’t bring in steady income by hoping for a 3 σ event to magically save our trades, so we definitely did the “right” thing. All we can do now is keep on top of our current situation.

If the rally resumes, we’ll adjust accordingly. Until then, we just have to keep a close eye on IYR to see whether yesterday was a false move or the start of a new trend.

Last week the market continued lower despite being deeply oversold, putting one of our Calendar Options positions in adjustment territory for the second time. It’s been a wild ride for EEM: After a decline of more than $3 Wednesday, the ETF dropped another $1.50 in early trade Thursday morning, to a low of $127.92, then rallied back above $130 before retreating again with the rest of the market.

IYR fared better last week. Even though the real-estate ETF fell along with almost everything else, we still were showing a profit of about 8%. If support in the $59 area fails, we’ll probably hit an adjustment trigger before IYR consolidates or rebounds. Tuesday morning’s pending home sales data will likely be the catalyst for any major move, up or down. But it’s EEM that we need to keep our eyes on this morning.

On Thursday the emerging-markets ETF closed almost $4 under where it was when we made our first adjustment. EEM was well below our lower strike and was fast approaching our adjusted break-even point. What’s more, shifting implied volatilities had let some air out of our double-calendar adjusted position, pushing our current projected lower break-even up to around $129. Ordinarily we would’ve adjusted the trade Thursday before the close, but a thin market in the final hours before the holiday weekend had option prices bouncing off the walls.

So what we’re looking at right now are four possible scenarios:

• If the market rallies today and EEM goes along for the ride,. . . Yipee! We’re back in the profit zone.
• More likely, EEM will stay flat or move lower, at least for today. In Wednesday’s post about How We Adjust, we wrote that it’s usually best to spread out our position when the market gets volatile, but sometimes it’s better to roll to a single strike. This may be one of those times. Although our textbook adjustment at this point would be to roll half of our remaining 140-strike position down to 125 or 120, rolling all of the remaining contracts at 140 to 130 actually might result in a better risk profile.
• The other option, in case of a decisive downward move, would be to roll all our contracts at 140 even lower, to 125. If EEM plunges below $126, this might be the best choice.
• As a last resort, we might have to stop out—we closed Thursday uncomfortably near the range of our 20% to 25% maximum loss, and a gap down this morning would put us well into our stop-loss zone. But we’ve had three days for time decay to work its magic (option pricing models typically calculate time decay based on calendar days, not just trading days), and if we can eliminate most of our delta risk without killing theta, and come out with break-evens reasonably close to technical price support, we’re going to try to stay in this position long enough to end up with little or no loss.

What’s tricky about this (probable) adjustment is that we’re in a place where the chart tells us we could see a dramatic reversal, but perhaps not until there’s a climactic sell-off. EEM could shoot back up to $135 in a matter of one or two days—but it could just as easily plunge to $125 in the same timeframe before rebounding,. . .or dropping further. Unfortunately, we can’t tell the future; that’s why it’s important to exercise discipline when trading instead of succumbing to hope or fear, and that means following our trading rules, adapting to current conditions, and controlling our risk by stopping out if necessary.

We talk a lot about why adjusting iron condors is rarely, if ever, a good idea, and adjustment decidedly is not a part of the Condor Options strategy. So you’re probably wondering, why all these Calendar Options posts about adjustments? The answer is simple—calendar spreads are not like iron condors.

A quick review: As we explained in Part I of this series, our decision to adjust calendar spreads is based on the same criteria as our decision not to adjust iron condors—probability. When we open an iron condor, we typically have nearly a 70% chance of expiring out of the money. And as long as we’re out of the money, we can keep most of our initial credit when we close the trade. Our winning trades have an average return of 23%, and a few have returned more than 30%.

A typical calendar spread, on the other hand, has only a 30% to 50% probability of being profitable when the short option expires. If we’re lucky enough to be near the money when expiration week rolls around, we could have a 50% or 60% return; but if the stock is as little as half a standard deviation away from our strike, every dollar it continues to move against us can slice 10 percentage points off that return. If we expect to get high monthly returns from calendar spreads, month after month, we have to do something to tip the odds in our favor. One thing we can do is open a trade as a double-calendar, but even a double-calendar has only a 50% to 60% probability of profit if left as-is.

That’s where adjustments come in. Calendar spreads provide ways to adjust our trades that extend our range of profitability if the underlying moves too far in one direction or the other. Read the rest of this entry »

The July cycle so far has largely been a waiting game for our Calendar Options strategy. We wanted to wait until we’d closed out at least some of our June positions before opening our first July calendar spread. Then came a nasty expiration day, followed by the period of uncertainty heading into the Fed’s two-day FOMC meeting.

Today we again find ourselves sitting on our hands. We’d planned to open a second July calendar spread this morning, after the dust had settled post-Fed, but we got a dust storm instead. Sometimes the best way to trade is not to trade.

Nevertheless, it would be nice to balance the 48 delta of our EEM July/Sept 140 put position with another trade that has zero or negative delta, so if things settle down tomorrow we’ll be looking to open a bearish-to-neutral July/August calendar spread. But if the sell-off continues, we’ll have to focus on managing our risk by adjusting our EEM position ahead of the weekend.

We’re probably not the only ones who thought yesterday’s big rally was strange. Oil was up and so were airline stocks? Bond yields were down but the dollar was up? More people are pinching pennies by shopping at Wal-Mart and Costco instead of Kohl’s and The Gap, and investors pile into retail?

It didn’t make sense to us, either, but the market can behave irrationally long enough to do serious damage to our portfolio if we don’t maintain our discipline with respect to applying the rules of our strategy. Yesterday, those rules told us our RTH Calendar Options position had entered risky territory. If we had let our emotions get in the way and gambled on the fact that all the buying didn’t make sense, the trade might have been too far gone to be salvaged if the rally had continued this morning. But as it turned out, that wasn’t the case.

A number of readers have written to ask whether, now that RTH has pulled back, would we still make yesterday’s adjustment this morning. We make our decisions by applying our adjustment rules to where a position stands at the time—so no, if we hadn’t adjusted yesterday, we’d let the triple-calendar ride for the time being. Nevertheless, the adjusted position is still in pretty good shape too, and there’s no reason to make any change there right now either. (And because we did make the adjustment, future posts, and our performance record, will be based on the adjusted trade.)