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Who Else Wants A 46 Pecent Return On A Calendar Spread That Goes Wrong

by Uncle Bob Williams

The Calendar Spread is one of the main tools used by Options traders to generate income. While Calendar spreads require more active monitoring than Vertical / Condor spreads, their risk/reward ratio is much better. As we will see in this trade, Calendar spreads can produce significant profits for a trade that only lasts a few weeks.

To create a Calendar Spread, we wait until around 30 days (+/- 5 days) before the options expiration, and then we sell the strike 'at the money' of the current month, and we purchase the same strike either in the next month or the month afterward. This creates a debit trade, where you pay to enter the trade. The amount you pay is the maximum possible loss because your long strike will always have more time value than your short strike.

We were 30 days before the October expiration when we saw this GOOG Calendar spread.

=> The GOOD:

      (A) The Yield graph on this trade is awesome with very high yields: 14 Day Yield = 56%, Expiration Yield = 336%.
      (B) The trade area up to the breakeven points is wider than 1 Standard Deviation, which is unusual for a Calendar spread.
      (C) The anticipated time in the trade was small based on the yield curve.

=> The BAD:

      (A) The IV [Implied Volatility] Skew is at our safe range limit (and fluctuating over into the Red). Calendar spreads are very sensitive to IV changes and as great as the yield graph looks, the IV Skew is concerning. (more on the IV Skew below)
      (B) The price of GOOG was not stable, and a rapid price correction would be dangerous to this position.

Open Trade:
Sell 1 Contract | GOOG | October 2012 Expiration | 720 | Put
Buy 1 Contract | GOOG | November 2012 Expiration | 720 | Put
Spread Price: $4.35
Days until Expiration: 30

= - = - =
After 2 Trading Days

This position is already showing a Profit of 2.3%. There is still a borderline IV Skew, which is a little concerning, but the breakeven area for this trade is very large: past the 1 Standard Deviation marks which is good.

= - = - =
After 7 Trading Days

Now showing a healthy profit of 19.5%. We would normally exit (or take profits and reduce the position) at this point. The profit return is great, and there is the pending threat of Google earnings announcement 2 weeks in the future. However as an example trade, we plan to keep it going until the earnings announcement in 2 weeks. The profit/loss graph on this trade has a max profit of 430% at expiration! If Google stays in the price range, and the IV Skew doesn't get more out of shape, this trade could return a 100% plus profit.

= - = - =
After 8 Trading Days

The profit keeps growing: profit of 24.1%.

= - = - =
After 14 Trading Days

Oops. The position is still showing a profit, however it looks like everything on this trade is going wrong at this point. The market price of GOOG keeps rising, and getting close to our top break-even point (this is bad), and the IV skew keeps growing which is dangerous to our profits (also bad).

In the graph below we expanded the position detail box to highlight the IV skew.
An IV skew is where the difference between the IV values our short strike and our long strike gets too large. In this case, the IV of our short strike is getting larger in anticipation of the GOOG earnings announcement, which is bad for this trade.

Normally on a Calendar spread, the value of our short strike decays faster than our long strike which is the source of our profits. In this case, the IV our short strike is growing. When the IV rises, the price of the options rises. This is exactly the opposite of our desired progression in this trade. We want the short strike to decrease in value, not increase. Ouch.

= - = - =
After 15 Trading Days

The IV Skew keeps growing, but this trade is still showing a healthy profit.

Even though the underlying price is close to the breakeven point, this trade has a healthy profit in spite of the IV Skew. The pricing when we entered this trade was a dream, and even though the price movement and IV Skew are against us - this trade is holding its own.

The earnings announcement is causing the IV to rise on our Short Strike, but because the Short Strike is now 47 points / approximately 6% away, the IV Skew is not growing very fast. The IV changes are more severe at the strikes near the underlying price.

Possible Outcomes:

A) If GOOG jumps up past our breakeven point, this trade could have a loss, but compared to the potential profit, the loss is small.

B) If GOOG stays at the current price or goes down, this trade could have a massive profit. Max profit is 441%! After the earnings announcement the IV values will drop, and the IV of our Short Strike should drop more than the Long Strike. However leaving this position open through earnings could be very risky.

= - = - =
After 17 Trading Days

Yep, the IV Skew keeps growing. Profit now = 51.7%.

The GOOG price drop is helping this trade.

= - = - =
After 20 Trading Days

Profit of 47.1%

= - = - =
After 22 Trading Days

Profit of 46.0%.

Close position, and pocket a healthy profit.

= - = - =
Summary:

Calendar spreads have tremendous profit potential, but are very sensitive to price movements and IV changes. We saw examples of both above.

As long as the underlying price stays in a relatively narrow range for 2 to 3 weeks, the profit potential is very high. However, if the underlying does move to the break-even point the potential loss is gradual giving the trader time to adjust or remove the trade.

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