Condor Options

When we talk about a “calendar spread” here at Calendar Options, we always mean a horizontal spread (both legs at the same strike). But more than a few calendar traders will sell the near-month option a strike higher or lower, to give the position a bullish or bearish bias, and still call it a calendar spread. We prefer to make a strict distinction between these “diagonal” spreads and “calendar” (horizontal) spreads, and our core strategy is based exclusively on the latter—it is a market-neutral strategy, after all. Nevertheless, just how much directional bias a diagonal spread has depends the distance between the strikes and where they are relative to the underlying stock price.

For example, suppose we’re moderately bullish on MCD at around $57.50.  If we were strongly bullish, we might buy (sell) a 57.50/62.50 or 60/65 vertical call (put) spread, with Dec or Jan expiration, depending on how fast and how far we expect the price to climb. But we’re (hypothetically) only moderately bullish in the short-term, and we don’t think the price will be much higher than 60 at December expiration—although we expect it to continue higher in January.

A good way to play this scenario might be to buy the Dec/Jan 60/55 diagonal call spread (see figure, right). We’d get our maximum return if MCD is near $60 at December expiration, and if we’re still bullish, we could roll our short Dec 60 options up and out for additional profit. This way we’d capture the optimum December premium from our initial short position (given our $60 target price), and then take in what premium is left in the Jan 62.50 or 65 options when January becomes the near month (and the stock price is closer to the Jan strike we’re selling), while giving the stock more room to run.

As the P/L curve shows, however, this trade clearly falls into what we call the “speculative” category. With an initial delta of 86 on a $1200 position and theta of only 1.3, we’re betting that we’ll profit from an increase in the underlying price rather than from selling option premium. We have almost no downside protection, and the high delta makes adjusting the position for a drop in the underlying stock price very tricky. There would be nothing wrong with taking this trade if you agreed with the bullish thesis, but it doesn’t belong in the monthly income portion of our portfolio.

MCD Dec/Jan Bonus Trade—Analysis

The MCD Dec/Jan 55/52.50 diagonal Bonus Trade we entered yesterday, on the other hand, is significantly different. By positioning our strikes lower relative to the price of MCD at the time ($56.20) and narrowing the vertical spread, we have something that looks more like our usual, horizontal calendar spreads (see figure at left). A similarly sized position started out with just over one-third as much delta as the directional trade above, and the downside break-even price gave us a cushion of about $4. Our theta was 6.7—enough to profit from time decay like we want to—but vega, at 8.4, was no higher than that of our speculative diagonal example.

Moreover, the narrower vertical spread makes our position behave closely enough to a horizontal calendar that we should be able to take advantage of the same adjustment techniques we use for standard Calendar Options trades. If MCD moves too far up or down, we’ll look to extend our profitability range by rolling part of our position to a calendar spread at a higher or lower strike. The main difference is that, on the upside, we’ll probably want to adjust before MCD reaches the expiration break-even point ($62), in order to boost theta and bolster the top end of the expiration profit curve.

Just to be perfectly clear—this trade falls outside the scope of the Calendar Options core strategy. It’s a defensive variation that we adopted to hedge against falling implied volatility. Nevertheless, we were careful to avoid too much directional bias and to preserve enough calendar-spread characteristics that we expect to be able to apply our Calendar Options adjustment approach if needed.