In all our Calendar Options trades, we’ve been stressing that our strategy requires establishing positions initially having an even number of contracts, with a minimum of two contracts per leg for a double-calendar and four contracts per leg for a single-calendar. Reader Rob H. writes:

I took the Bonus Trade in IBM (Jun/Jul calendar) and had my order in for 8 contracts. Only one contract got filled at my price, and the market price has kept slipping away ever since. Since I couldn’t get an even number of contracts to apply position adjustments if necessary, do you think I should just pull the plug on this one?

Not necessarily, Rob. With a single calendar spread, our first adjustment strategy is to widen it into a double-calendar. The main reason we want to start a single-calendar with four contracts is so we can make adjustments without having to double the size of our position. For example, if we decided that the amount we want to risk on a particular trade is $3000, we don’t want to be forced to put in another $3100 and throw off the balance of our portfolio. So the split-position approach is intended to prevent an unexpected need for large amounts of new cash that we hadn’t planned to risk on that particular trade.

However, if we had tried to trade more contracts but couldn’t get filled, it’s okay if the adjustment adds to our position (assuming we kept cash set aside for this purpose)—because we had originally wanted a larger position. If IBM were to fall to $121 this week, for example, our usual strategy would be to sell half of our spread at 125 and to buy an equal (half) position in a calendar spread at 120. This would move our lower break-even point down and widen our profit zone, with only a small infusion of additional cash. On the other hand, if we wanted a bigger position anyway, we could just keep our full position in the 125 spread and add to it with a full position at 120, doubling our overall investment in the trade.

If we were to reach a point where a second adjustment is necessary, we could look at it similarly. The typical level-two adjustment would be to sell half of the position at 125 and open a half position in a 115 calendar spread, to form a center-weighted triple-calendar. But if we wanted to increase our position, we could just buy a full position at 115 to create an evenly weighted triple-calendar; depending on what the risk graph looks like, we also might want to add to the spread at 120.

There is one caveat, however. If a position needs adjustment, it might be because the underlying stock and/or the market is getting more volatile—perhaps dangerously so. In that case, we wouldn’t want to increase our risk on a trade that could be spinning out of control, and we’d have to take a loss and move on to the next opportunity. So if we’re sitting on a nice little profit right now (this morning our 125 put spread is trading about 8.8% above where we bought it less than a week ago), it’s worth giving serious thought to the fact that a pretty handsome return might turn into a loss because of the additional risk that a doubling-down adjustment strategy entails.

Regarding Monday’s Bonus Trade, reader Carl M. writes:

A May 50/55/60 call butterfly on GRMN at $0.60 or less leaves a very good potential profit range from 50.60 - 59.40. Any thoughts on that approach?

We intended this to be a purely directional trade, with room to run on the upside - but recognizing that there’s a good chance any rally the stock might see could be limited, the butterfly strategy has a lot going for it:

• Maximum potential profit - on a percentage basis, more than 400% if the stock price is in the vicinity of $55 near expiration - handily beats the two spreads suggested in our original post;
• It would be reasonable to expect at least a 100% return if the stock price is in the $50.60 to $59.40 range at expiration;
• Because of the low cost, the risk in case of an unexpected plunge in the stock price is very low - as long as you don’t bite off a bigger position than your risk tolerance warrants;
• Theta becomes positive when the stock is above $48 or $49, which is a significantly lower threshold than for the May 50/55 spread (a good thing), but slightly higher than for the May 55/June 50 diagonal.

All in all, this looks like it could be a good strategy…but you have to watch out for the upside risk. If GRMN is at or above $55 on April 29, a positive earnings surprise on the 30th, although unlikely, could push the stock up to $60+ and wipe out your gains, at least temporarily. So it might be a good idea to lock in profit (or at least a portion of it) on the 29th if the stock closes above $53 or $54.

Alternatively, you could add another May 60 call to the position. This would raise your break-even point at expiration to $51 or $52 and diminish your maximum theoretical profit; but you could still have a 100% profit if the stock is above about $50.40 the day before earnings, and you’d be biased to the up side if you want to bet that the news will be good (but your risk in case of a big gap down on bad news would be about 30% greater).

Of course, after today’s sell-off, which hit tech stocks especially hard, this discussion may be academic anyway. GRMN broke trend-line support in the first half-hour of trading and fell through our $43.75 stop-loss threshold shortly after noon. But the bump in volatility premium that accompanied the drop kept us in the trade, and although the official close was $43.73, we saw a buyer come in at the bell and push the price over $43.80. The last after-hours trade tonight was at $43.90.

So you might look at the pull-back as a golden opportunity to get in at a discount, or a warning to cut your losses and move on - depending on what happens tomorrow. (Not that it really matters, since we don’t suggest you bet any serious money on these bonus trades of ours. No way, no how. Nevertheless, we’ll be watching GRMN closely at tomorrow’s open.)

Reader Tony L. asks about the plethora of names for option spreads out there:

I’m not a novice trader, and I’ve read a few books on options. But to be honest it’s hard to keep track of all the different kinds of spreads out there, especially when you start doing trades with three or more legs. I mean I know the terminology: verticals, diagonals, butterflies, iron condors, double diagonals, calendars, etc. But how to keep them all straight in my head; how do I know what spreads to use, and when? Thanks.

Great question: especially when you’re first getting started in options, it can be daunting to have to learn what all those spreads are. It seems like homework - and is definitely more complicated than flipping stocks, right? Compare: you have a stock, and you can buy it or sell it. Or you have an underlying stock or index or commodity, and you can trade any number of spreads on that underlying, and you can sell the spread to open, or buy the spread to open, and you have to choose an expiration cycle, and…

But it needn’t be so complicated, once you realize that trading option spreads is all about managing risk. And when it comes to risk-defined options spreads, there are actually only two types of spreads, from which all other traditional spreads can be constructed. They are:

• Calendar spreads - in which you are long (short) one option that expires in a nearer month, and short (long) another option that expires in a farther month.
• Vertical spreads - in which you are long (short) one option that is closer to the underlying price, and short (long) another option that is farther from the underlying price, where both options expire in the same month.

Can we really explain all those other complex spreads in terms of these two simple constituents? Let’s find out:

• Diagonal spread - is just a vertical spread plus a calendar spread, where one of the vertical options overlaps with one of the calendar options. Example: put together a long SPY May 134/135 call vertical, plus a short SPY May/June 135 call calendar, and you get a short SPY May/June 134/135 call diagonal.
• Iron condor - is just two short verticals (a short vertical call spread and a short vertical put spread) stuck together.
• Butterfly - a butterfly is just a long vertical plus a higher or lower short vertical.
• Double diagonal - is just what it sounds like :)

Brain teaser: what about straddles and strangles?

Member R. writes in with a question that gets asked quite a lot:

I noticed that your two current trades have a credit of around .60 to .70. Doesn’t a trade for this amount of credit generate a lot of commission expense?

What do you do about commissions? Is that just part of the cost to do the trade?

So yes, on the face of things, it does look like iron condors impose higher commission costs. But that’s an illusion - in the sense that if you sell a call vertical today to fade a rally or something, and then you turn around and sell a put vertical tomorrow or the next day to fade weakness, you’ll end up with an iron condor and you’ll have paid just as much in commission costs (assuming fixed, per-contract costs; if you pay any kind of ticket charge, then obviously entering the trade all at once costs less). But the funny thing is, you don’t typically hear people complaining about the incredible commission burden of vertical spreads or calendar spreads.

R.’s question is totally appropriate, and it’s actually kind of commendable to keep an eye on transaction costs: many retail mutual fund investors, for example, are notoriously bad about paying attention to fees and costs.

At the same time, some people get so exercised about transaction costs that they spin themselves into inaction. I mean, if your primary goal is to pay as little in commissions as humanly possible, there’s an awesome strategy out there that will allow you to pay ZERO commissions for all eternity. True, it often lags the market averages, but it is beating the markets so far this year. The only downside is that it always gets beat by inflation. We’re thinking of offering a newsletter based around this strategy, if anyone is interested. The newsletter will be called “Cash”.