Condor Options

In Part I of our series on Calendar Options adjustments, we explained why adjusting calendar spreads is often a good idea, and we showed how an adjustment can turn a position that has gone against us into one that’s even more likely to reach our profit target than our initial trade. But how do we determine when it’s time to make an adjustment?

The smart answer is, when we think the odds of reaching our profit target are better with the adjustment than without. . .but there’s more to it than that, of course. We look for clues that the trade might be at risk of getting out of control—the stock moving unusually fast, the position showing a loss close to the maximum we’re willing to tolerate, or the underlying reaching (or getting too near) a price where we’d have a loss at expiration. Let’s take a closer look at each of these criteria:

• The price of the underlying is near a break-even point. This is the easiest way to tell that a calendar spread might benefit from adjustment. A break-even is a price where the expiration profit/loss curve crosses from payout to “pay up”. As noted in Part I, the probability that the price will touch a break-even and keep on going is significantly greater with a calendar spread than with an iron condor.
• We’re close to our stop-loss limit. Without adjustment, calendar spreads have a lower probability of profit than iron condors, and the theoretical maximum loss is 100%. That’s why our Calendar Options strategy incorporates (mental) stop-loss limits—we don’t want one bad trade to wipe out our gains from the last three good ones. If a position has lost 20% of its net value, it’s probably time to take action.
• The price of the underlying is moving too fast. If there’s a sharp rally or sell-off, that’s a sign that there might have been a change in investor opinion sufficient to spark a trend—and with non-directional calendar spreads, the trend is not our friend. We determine how fast is “too fast” probabilistically, by comparing the change in price over a period of time with the standard deviation for that period. If the price of a stock moves much more than 1 ? over a period of a few days, that’s extraordinary. If an equity underlying one of our calendar spreads moves against us by 1½ – 2 ?, we probably need to make an adjustment. A 2½ – 3 ? move is a danger sign, and we’d have to consider adjusting immediately or closing the position.

Even though all of the above are warnings that warrant some attention, none of them alone automatically triggers an adjustment,. . . except maybe when the stock price has moved past a break-even point. We also look at the chart of the equity to help decide whether it’s trending against us, as well as consider general market sentiment. In addition, we analyze the adjusted trade so we can see exactly how much better off the adjustment will make us (or not).

Let’s look at an example. On May 28th, eight days after we opened our IBM June/July 125 calendar spread, the stock was up more than $2 on above-average volume, after gaining $3.12 the day before. The May 27th move was more than twice IBM’s one-day standard deviation, and the rally for both days combined was 2.7 times the two-day ?. What’s more, even though it looked overbought on the weekly chart, the stock had broken through its previous, multi-year high, confirming that the up trend it had been in since December wasn’t over yet. (See chart.)

As the profit/loss graph at the right shows, by the time IBM reached $129.15, it was $0.40 above our position’s upper break-even price. We were carrying a loss of 8%, still well below our stop—but with our position delta close to -32, another $2–$3 daily gain could have put us right there in no time, and we’d be at the point where we’d have negative theta (i.e., we’d be losing value from time decay instead of gaining). Our up-side risk was getting too high, so we needed to do something.

To make more room at the upper end, without exposing ourselves too much on the down side, we wanted to roll half of our position up to the 120 strike. (We’ll talk more about how we make adjustments in Part III.) We took a look at the risk graph for the adjusted position (figure at left) and saw that our new upper break-even would be above $131, but our lower break-even would still be under $124. The adjustment would cut our delta 70% and boost theta 32%. Which position would you rather be in with IBM above $129 and looking like it was heading higher? Yeah, that’s what we thought too, so we made the adjustment.

As it turned out, the rally slowed and IBM fell back below $128 two days later. We’re currently showing a net profit of 6.4%, which is less than the 10.3% that the unadjusted trade would’ve yielded as of yesterday’s close. So should we have made the adjustment?

Absolutely. Sure, we like to reach our 15%–20% profit target as quickly as possible, but earning income consistently from calendar spreads isn’t about gambling on fast profits. It’s about effectively managing our risk/reward profile in a manner that gives us steady returns and avoids deep drawdowns. And that means having the discipline to adjust a trade before it gets out of control—but only once it’s clear that we’ve reached our risk-tolerance threshold, as defined by the position’s break-evens, our loss limit, and the degree to which recent price movement has exceeded statistical norms.