A steady decline in implied volatility through the first week of the new year weighed on our positive-vega calendar positions, narrowing their profitability ranges and pushing down their unrealized gain/loss. Although the January cycle saw a drop in intermediate-term price volatility, the period was dotted with short-term whipsaws, which our vega losses made more difficult to tolerate without adjusting. With the combination of dwindling IV and fits of short-term volatility working against us, the average loss for our two trades was in our maximum allowable (stop-loss) range. We knew going in, though, that volatility risk was still high, so we stressed the importance of trading scaled-back positions, to keep any percentage loss relatively small in dollar terms.
- S&P 500: –4.25%
- Dow Jones Industrials: -3.47%
- Russell 2000: -4.07%
- S&P 500 Covered Call Fund: 2.55%
- Calendar Options: -14.18%
- Note: The period measured is from expiration to expiration.
In order to present a more realistic picture of Calendar Options performance, we’re now calculating returns based on a model portfolio allocation. We initially size each hypothetical position at 25% of the total portfolio value at the beginning of the cycle; with a maximum of three trades per month, this leaves at least 25% initially in cash for adjustments, if needed. Note that the model portfolio is not intended as a recommended allocation or investment advice.
January Calendar Spreads
- UNP Jan/Feb Double-Calendar: -30.47% return – We selected UNP on the thesis that an earnings announcement scheduled in the back-month options cycle, immediately after January expiration, would help cushion our long position against a decline in implied volatility. To avoid excessive vega, we’ve been keeping our spreads one month apart, so we also needed a stock that had February options trading at our time of entry. Once we’d applied our other filters (volatility characteristics, stock price range, liquidity), we had very few stocks to choose from, and UNP appeared to be as good a candidate as any—but that didn’t turn out to be the case. An analyst’s comments unexpectedly sent the railroad off the tracks (down almost 13% in the first two days of our trade), triggering an adjustment lower. That left us in a vulnerable position when the New Year rally took hold and drove the stock up more than 17% in five trading days. We stayed with it, though, knowing that the bulls would have to run out of steam eventually—until the rally ended with a spectacular $5 drop the day after our fourth adjustment. We decided to call it quits rather than make more adjustments and risk greater losses, and that decision came just in time: UNP fell another 19% over the next week and a half into expiration.
- SPY Jan/Feb Calendar Spread: -9.80% return – The story was similar for our SPY position, only not so extreme. An early adjustment lower set us up for a whipsaw at the peak of the New Year rally. We rolled back down ahead of the weekend before expiration week, because we didn’t want to risk a greater loss in case of a gap down Monday morning; but we thought that an oversold bounce at trendline support could arrest the downtrend long enough to give us a little more time decay. When the selling continued on Monday, we chose to close out rather than face expiration-week gamma in a strong downtrend.
Even though January was a double disappointment, we were “successful” in the sense that we kept our average loss within acceptable limits, knowing that we can erase the bulk of a maximum loss with a target win. Nevertheless, we don’t take a major loss lightly. The January cycle taught us some important lessons:
- Stick to our short-list of well-behaved stocks. It isn’t very hard to find stocks that tend not to move around a lot, even in bear markets (relatively speaking), nor is it difficult to find options with a lot of premium to sell—but we know of only about ten stocks and ETFs that combine those characteristics to create the right risk/reward profile for our strategy, and meet our other selection criteria (which we’ll discuss in a future post). Certainly there are other good candidates, but we want to take a very long, hard look before trading any new underlying.
- If implied volatility is high, modify the strategy to reduce vega risk. The high vega of a straight horizontal calendar spread is something that we can use to our advantage—but it also carries substantial risk. If IV is relatively high when we’re in our time window for opening trades, we can manage vega, and thus volatility risk, by including one or more double-diagonals in our portfolio. We introduced the double-diagonal in a two-part series of posts (Part I, Part II) last month, and feedback from members was overwhelmingly in favor of including the strategy in our newsletter trades.
- (Bonus lesson) Use #2 to make #1 less restrictive. The vertical component of a double-diagonal can boost our profit potential enough, compared to a double-calendar position, to make placid stocks with low IV (such as JNJ) viable underlyings for Calendar Options trades. Alternatively, it can allow us to widen the distance between short strikes enough to accommodate more price volatility (e.g., IWM).
As long as we’re in a bear market, implied volatility will almost certainly remain in a range that carries higher-than-normal risk for a market-neutral calendar-spread strategy like Calendar Options. We recognize the risks (adversity sharpens the senses and focuses the mind) and have taken measures to manage them. Nonetheless, it’s also important to recognize that we want to be in at least one calendar-spread position every month, if possible—because a calendar trade complements our negative-vega positions, and when it goes well, it’s perhaps the quickest way to get a high return with a reasonable level of relative risk.