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Last edition of Profit Talk we covered a favorite cash flow strategy, the short version of the Straddle. Called a “Short Straddle”. We used the Straddle as the entry tactic for a Range Bound Round Trip strategy. In that case the current volatility situation is not as important because ownership of the shares is taking place as part of the strategy. But, as mentioned, the Short Straddle on it’s own should only be used in high implied volatility situations. I had hopes for a volatile start of the new year but so far, outside of a few specific areas of the market, volatility has remained very low.
As you’ve learned, selling premium, like in the case of the Short Straddle, offers a higher probability for profit than directional trading does. But, you have also learned that premium selling strategies, called credit strategies, perform better when entered during high implied volatility periods, relatively speaking. Meaning, when the current “implied volatility” compared to its historical range is high. The current volatility is given a percentage value as compared to its historical valued. This value is called Implied Volatility Percentile, IV Percentile or IVP for short.
All credit based strategies perform best if entered when IVP is high in that particular market. Many option traders, myself included, prefer the consistency that premium selling strategies can bring coupled with the ability to create a variety of non-directional style trades. For this style of trader, there is very slim pickings when volatility remains low for extended periods of time.
Fortunately, as is always the case, options give us a variety of alternatives to fit any market situation. When IVP is low, we do the opposite of when it is high. This means we buy premium rather than sell it. These “buy” style option strategies are called debit style strategies. This is because we pay, or are debited, when entering the trade. It’s the opposite of what happens when we enter a credit style trade. Remember, we receive a credit when entering a credit style trade.
Low IVP is simply saying the premium prices are currently low compared to their historical average. That’s why buy style strategies are preferred, because the premium is on the low end of it’s range and profitable traders look to buy low and sell higher.
Debit strategies can be used to create directional or nondirectional positions. This edition we’re going to cover the nondirectional style debit trade. However, debit style directional trading offers great advantage when it comes to directional trading. Details regarding that style of trading was covered in the December 5th, 2016 edition of Profit Talk called “Directional Trading Options”.
This edition of Profit Talk we’re going to look at a versatile debit style strategy designed for the trader who does not want to rely on a directional move, but prefers to profit from the passage of time, as in the case of credit style strategies. As mentioned, options offer a solution for every market situation. The solution for those of us addicted to premium selling, or non-directional strategies, faced with extremely low volatility markets, comes in the form of the horizontal style option strategy often referred to as a “Calendar Spread”.
The Calendar Spread can be constructed to be either directional or nondirectional. It is the type of spread to use when the market is slow moving and range bound. If a strong directional move is anticipated, another directional style debit trade would be better suited. However, when volatility is extremely low, and relatively small moves in the price is expected, the Calendar Spread offers the perfect solution. Calendar spreads offer a great way to place either non-directional or slightly directional trades while in low volatility situations.
The Calendar spread is considered a horizontal style spread. This is because the two strikes used to construct the spread use the same strike price but different expiration dates. A longer duration option is purchased and a shorter duration option is sold to create the spread.
The Calendar spread can profit two different ways. First, the position will profit from the time decay experienced from the short duration option. This option decays at a faster rate than the long duration option. Profit is made from the spread between the slower decaying option and the longer decaying option.
Second, the Calendar spread can profit with a rise in volatility. Remember, when volatility is low it’s better to buy premium. If you own or are long premium which is volatility, and volatility rises the option price will rise as well. The purchased or long option will increase in price when the volatility rises. At the same time, the short option side of the spread will suffer from a rise in volatility. A short option is short volatility or premium and therefore suffers when the price of it rises. But, just like in the case of time decay, the Calendar spread capitalizes on the spread between the long duration option and short duration option. Volatility has a stronger effect on longer duration option prices than shorter duration option prices typically speaking. Meaning, outside of effects that stem from a near term event such as earnings. Since volatility has more effect on longer duration options, the position will profit as the gain from the long, longer duration option rises more than the loss volatility inflicts on the short, shorter duration option.
A rise in volatility can produce profit for a Calendar which means a fall in volatility can cause the position to experience a loss. Because of this, Calendar spreads perform better when placed in markets during low volatility conditions. Generally speaking, it’s best to use a Calendar spread in markets with an IV Percentile that is 30% or lower.
The best outcome for the Calendar trade is for the stock price to go nowhere. The closer the strikes are to price when the short strike reaches expiration, the higher the profit will be. The maximum profit for the position occurs if the stock is at the strike price at the time of expiration. In the end, this position profits when the stock price stays in a fairly small range in price. However, Calendar spreads can be constructed with either an up, down or sideways directional skew.
Searching for candidates is quite simple thanks to modern tools. The trading platform can be used to filter through the markets to find prospective candidates.To create a scan for trade candidates go the to the scan page of the platform. We are going to create a custom scan query.
First, choose the universe of stocks the scan will look in. Use the drop down menu, under “Category” choose “All optionable”. (Figure 1)The first two filters that need to be created are general volume and price per share minimums that are used for every scan query. Add the price per share filter by clicking the “Add filter for stock” button in the upper left corner. Use the drop down menu and select last. That refers to last price. The minimum share price I would generally use would be about $15. But, when it comes to Calendars, they are best used on stocks that are higher in price as long as the account balance has the buying power. Stocks trading $75 and above are preferred. The $100 range is the sweet spot. Adjust according to the account size.
Set the last minimum share price to $75. Now add another filter for the volume. This refers to the average number of shares traded per day. All else being equal, higher volume markets are always better to trade than low volume markets. This fact is magnified when trading options. In reality, the best markets for option traders trade 5,000,000 shares or more per day. But, there are adequate markets that trade as low as 1,000,000 shares average per day among individual companies and even a little lower than that among the ETFs. In general, I use 1,000,000 shares minimum and then sort for the highest volume markets among those to consider. Based on the current low volatility condition, we will have plenty of candidates come up using 1,000,000 shares as a minimum. Click “Add filter for stock” and select “Volume” and put 1,000,000 as a minimum.(Figure 2)
Now, we can add the volatility percentile filter. This filter is what the platform calls a “Study Filter”. Click on the “Add study filter” button. Use the drop down menu and under the “Volatility” category, choose “IV_Percentile”. Remember, Calendar spreads perform better if entered when the IVP of that market is low, 30% or lower. Set the percentile range to look for markets with an IVP of 0% to 30%. (Figure 3)
In addition, since we are at the beginning of earnings season, let’s add a filter to remove any candidates that have earnings in the next 45 days. This type of position does not want any sudden and large price moves which earnings releases have a high chance of creating. We have other strategies for earnings events. Eliminate markets with a pending, near term earnings announcement by adding another study filter. Click “Add study filter”. Use the drop down menu and select the “Corporate actions” category and under that select “Earnings”. Set the earnings filter to look for companies that don’t have earnings anytime in the next 45 days. Use the drop down and select “Does Not Have”. Use the next drop down menu and choose “Anytime” . Finally, put 45 as the number of “bars”. (Figure 4)The default setting for the filter is the daily chart. Confirm you’re using a daily based filter by looking for the letter “D” on the right side of the filter. The daily filter will cover the next 45 days.
This will look though all optionable stocks to find those that are trading for at least $75 per share with a volume of 1,000,000 shares per day on average and don’t have earnings in the next 45 days.
Now click scan to run the query. In a matter of seconds the results are shown. There are currently 37 markets that fit the criteria. (Figure 5) These can be sorted by clicking on the top of the column. Sort by IV percentile, volume, share price, etc. This list can be saved by clicking on the right upper corner of the list and choosing “Save as Watchlist”. It can be pulled up in the quote window by selecting it under personal lists.
The final decision as to what market to enter should first be based on the “Delta Match” considerations of your current portfolio. This subject was covered in the 12-12-16 edition of Profit Talk called “Balanced Portfolio Techniques”. In summary, choose a market that does not cause your portfolio to become too heavily weighted in any one market or sector or with any with anyone one type of option strategy. If necessary, review the 12-12-16 edition for details on “Delta Match”.
Once you’ve filtered prospects based on the Delta Match considerations, chart analysis and/or option market analysis can be performed to make the final selection for which market to use. The best candidates based on chart analysis are the markets with the smallest range in historical price movement. However, it’s best to avoid markets that are currently in a compressed range as shown by a tightening of the bollinger bands. (Figure 6) These circumstances typically lead to a “break-out” of price after a period trading in a very tight range. This is the case in many of the main US market indexes which are all at the top of our list when sorted by volume. A Calendar would of been great to put on in those markets a few weeks ago, because in retrospect price has stayed in a tight range, but now it’s probably too late. They now carry too much pent up volatility in my opinion.I would avoid using a Calendar in markets where the bollingers bands have collapsed inward.
After eliminating those, what’s left among the top volume prospects is the one major index not bottled up in tight range, the Nasdaq 100 index, ticker QQQ. This ETF contains the largest 100 companies traded on the Nasdaq stock exchange. Also, TLT which is a US treasury ETF, GLD which a gold market ETF, IYR and VNQ which are both in the US real estate sector. (Figure 7) These four markets are all affected by interest rates and/or the US dollar. For this reason, their correlation to each other should be analyzed and considered. I’d like to pick two unrelated markets to place Calendar spreads on. Let’s go with the Nasdaq 100 ticker QQQ and and interest rate play the US treasury market TLT.
I just want to mention that another fact typically considered when looking for trade prospects is the option contract volume. Low option contract volume is avoided. But, that step won’t be necessary on these very popular and high stock volume markets. Let’s construct a non-directional style Calendar spread in the Nasdaq 100 ETF which is ticker symbol QQQ and is often referred to simply as “the Q’s”
To create a nondirectional Calendar spread, use 1 long ATM option with 90 days or more to expire and 1 short ATM option with 60 days or less to expire. Again 40-45 days is the sweet spot for selling options, but anywhere under 60 days is acceptable. When buying options, we want their expiration far out in time even though they are more expensive. The further out in time we go, the slower the options will decay. This allows us to keep more of the credit from the short option we sell which is also decaying.
We use Calls when price is slightly below the middle of the range or closest strike and Puts when price is slightly above the middle of the range or closest strike to construct the spread. A chart technical indicator called the “Bollinger Band” indicator can be used. The middle line is the middle of the range and the outer lines represent the upper and lower point of the range respectively.
Let’s go through the steps of constructing a Put Calendar spread for the, Nasdaq 100. Ticker symbol QQQ. Looking at the chart, you can see that price is currently above the middle of the range. (Figure 8) This means we can use Puts to create the Calendar because if price does revert to the mean that will bring it down in price. Don’t over think whether to use Puts or Calls. In the end, the correct one to use is never known until later because it depends on where price ends up going between now and expiration. The simplest way to choose is to decide based on the strike price you want to use. If the strike you want to use is above price use Calls to create a “Call Calendar” and if the strikes you want to use are below the current price use Puts to create a “Put Calendar”.
To construct the spread go to the analyze page and type the tick symbol in the upper left corner of the screen. Here are the option expirations available. Choose a 90+ day expiration for the long option. The April expiration is 95 days away. Let’s go with that expiration for the long Put. The ETF is currently trading for $123.16 per share. Choose the closest Put strike under the current price. That is the $123 strike Put. Click on the “ask” column of the 123 Put to buy it.
The next step is to sell a Put option of the same strike with a shorter duration. Choose an expiration with less than 60 days to expire that is closest to 45 days. Let’s go witht the March 3rd expiration which is 46 days out. To add this option the existing option sitting in the order bar, hold down the ctrl key and this time click the 123 strike “bid” column to sell a Put. If done correctly the order bar recognizes the spread and names it a Calendar. (Figure 9) The order bar shows 1 long QQQ April 21st expiration 123 strike Put and 1 short QQQ March 3rd expiration 123 strike Put. It is a Debit style trade will cost $1.52 per share or $152 per spread on the standard 100 share contract.
The maximum loss potential on a debit spread is what you pay for the spread. That means the maximum loss on this trade is $152 per spread. The maximum gain can be found on the risk profile page. The blue line shows the P&L based on the day of expiration. The magenta line is the P&L realtime. (Figure 10) You can see the maximum profit comes if price is right around the strike price on expiration. The maximum profit is about $115 per spread. The profit diminishes until reaching the breakeven points. The downside breakeven is a QQQ share price of around $120.25.The upside breakeven is around $125.83 per share. Any further move in price beyond those points will create a loss on the trade.
The good news is that Calendar spreads have limited risk and relatively low risk for loss when compared to buying the stock. If you bought 100 shares of this stock it would cost $12,300 and that’s what would be at risk. The trade could only make money if the stock went in one direction and would lose money equally every penny in the opposite direction it moved.
On the other hand, buying 1 Calendar spread would cost and risk only $152 no matter what happens to the stock price. The spread will make at least something if price closes in a range of around $2.50 below or above the strike price on expiration. The downside compared to straight stock buying is the maximum profit is limited.
The key to successfully trading Calendar spreads is to be very aggressive with profit taking. Never try for maximum profit on a Calendar spread. Take profits on the position once the 25% profit point has been reached as a minimum and 50% profit point reached as a maximum. If the position consists of more than one spread, ½ of them can be sold at the 25% profit point and the other ½ at the 50% profit point. Replace the closed Calendar by opening a new Calendar and keep repeating the process.
Debit spreads are bought or long spreads. They are bought to enter and sold to exit. The profit point sell prices must be determined and the sell orders pre-scheduled to maximize profitability on the Calendar spread. The price to sell the Calendar spread in order to exit the trade and take profits is determined by multiplying the debit price or entry price of the spread times the percent of profit desired. The example spread cost $1.52 per share. If taking profit at the 25% of profit point, then multiply $1.52 by 1.25. If 50% profit is desired then multiply by 1.50 and so on.
Once the order has been filled. Locate the order on the Monitor page and open the full order to see both legs of the spread. Hold down the ctrl key and click on each leg to highlight both legs. Let go of the ctrl key and right click on the highlighted legs. Choose “Create closing order”. This will load the order bar with your sell order and bring you to the order page. Adjust the number of spreads to sell to close and make sure to select the correct sell price as the profit point price determined by the calculation.
In our example trade the 25% profit point would mean selling the spread for $1.90. $1.52 X 1.25 = $1.90. Make sure the order type is Limit. Also, make sure to select GTC “good ‘till cancel” or it will expire after today. OK, check to see everything is correct. If the first order is for a portion of the complete position add the order for closing the remainder of the position. To do this change the Advanced Order setting to “1st trgs Seq”. Now right click on the order and select “create duplicate order”.Adjust the lot size to reflect the number of spreads remaining. Adjust the credit price to sell for an amount equal to the original debit price, plus 50% of the full potential credit. So, the original debit cost time 1.5. Make sure it’s a limit order, change it to GTC. Check to make sure everything is correct and click “Confirm and send”. (Figure 11) Once the first order for closing at the 25% profit point executes and is filled, the second order for closing at the 50% profit point will become the sitting order. Both orders can be found on the Monitor page under working orders.
As an exercise, follow the process just outlined to create a Calendar spread for the 2nd pick in our line up, the 20 year treasury ETF, ticker symbol TLT or either of the other top candidates which are Gold GLD, Real Estate IYR and VNQ. Monitor the correlations in your portfolio and among the prospects with “Delta Match” and “Strategy Match” as outlined in the 12-12-16 edition of Profit Talk called “Balanced Portfolio Techniques”. Hint: IYR and VNQ are highly correlated and basically the same trade.
The main takeaways when it comes to Calendar spreads are first, enter Calendar spreads when the particular market IVP is 30% or lower. Second, Calendar spreads profit from theta decay and rises in volatility. Third, they are low risk but also low profit, aggressively manage profits for best results. Keep replacing closed trades with new trades. The idea is to create a balanced portfolio with diversified option strategy types. Calendar spreads can be one such type and receive a portion of the assets available in the account for trading.
Looking to the broad markets, the S&P 500 and the Dow Jones Industrial averages are still stuck in a very tight range with very low volatility as you know from our previous analysis. The Dow it still flirting with the 20,000 mark and managed to reach its previous high of 19,983 to the penny this past week before retreating. But, the Nasdaq 100 as represented by the “triple Q” ETF, ticker QQQ has broken above previous highs and is continuing higher as of Friday’s close.
In terms of high impact news or reports due out this week. Monday the markets are closed for the Martin Luther King holiday.
Tuesday 1/17 - Treasury secretary Lew speaks at 10:00 am eastern
Wednesday 1/18 - The Consumer Price Index numbers are released. This report is tied to inflation expectations. Also, Federal Reserve chairperson Janet Yellen is speaking at 3:00 pm eastern. Get the popcorn ready.
Thursday 1/19 - Building Permits, Philly Fed Manufacturing index, Unemployment claims, Crude Oil inventories and Fed chair Janet Yellen speaking again.
Friday 1/20- Is the Presidential Inauguration and the new President Donald Trump is tentatively scheduled to speak.
As is always the case, any surprises among the reports or speeches has the potential to move the markets. Maybe this week will bring some much awaited volatility.
A Look Ahead
As far as next week’s Profit Talk topic, I’ve decided to leave it open at this point. I want to see how the market goes this week and choose a strategy that best fits the market condition.
I hope this has been helpful for you. If you have any questions or comments, please leave them below or reach out on social media. You can also email me directly with any questions or comments at email@example.com.
Thank you so much for being a Profit Talk subscriber. I look forward to joining you for next week’s edition of Profit Talk. Until next time keep trading and investing the Profit Effect way proven, consistent and stress free, just the way trading is supposed to be.