We’ve gotten a couple e-mails from members wanting to know what we would have done if yesterday’s adjustment order had gone through, in light of the huge sell-off after the Treasury Secretary’s bank-bailout speech this morning. As a reminder, we entered the following order yesterday, which expired without getting filled:
Day limit order
Sell to close 2 SPY Mar 71 puts
Buy to open 2 SPY Mar 76 puts
Buy to close 2 SPY Feb 77 puts
Sell to open 2 SPY Feb 82 puts
for a net debit of $0.05 or better.
Here’s what our risk curve would’ve looked like at about 2:00 today:
Now, hypothetically speaking, the easiest thing to do would be to close the trade. We could’ve sold the adjusted position today, in the initial bounce after Geithner’s speech, for a profit of more than 10% on total capital risked. The more interesting case, however, is what we’d do if we decided to stay with it a while longer.
First, of course, we’d consider the risk, which would now be more to the downside. Since not much has really changed, in terms of the fundamentals, though, we might anticipate the market finding support again around 820 on the S&P; so we wouldn’t really have to do anything right now. On the other hand, if we were getting nervous about our positive delta (now over 25 on a 2-lot base position), we’d consider the defensive adjustment we typically make to a double-diagonal when an underlying gets close to one of our short strikes—buying the complementary diagonal, which would turn some or all (depending on how many contracts) of our put diagonal into a double-calendar.
Here’s how it would work: Right now, with SPY above $83, hedging the entire put side would swing the position too bearish. That would be okay if we were making a directional bet, but our core strategy is supposed to be market-neutral. So we’d most likely start off buying a fraction (say, half) of our total position. That would mean for our base position, buying one SPY March 82 put and selling one SPY Feb 76 put, for a net debit of about $3.50.
The effect of this adjustment would be to move our lower break-even down more than $3, while leaving our upper break-even over $91 (see risk graph above). The main drawbacks are that we’ve committed additional capital, and we now have a more complex position that will take multiple orders to close. If we wanted to free up more cash, though, we could close the call side, or roll the March 97 calls down to 91, eliminating the margin requirement for the vertical dimension of the spread.
Another, equally reasonable, approach would be to close half of our position and lock in some profit, while letting the other half ride. In this case, we could still make the above adjustment later, if SPY were to drop below, say, $81. At that point, we’d probably need to hang on well into expiration week to get a decent profit on the remaining half of our position, but we’d have a good chance of doing significantly better on the second half than on the first—and even if we ended up with a small loss, we’d still have booked some profit on the first half.
Okay—so now, even though we’re keeping our real position as-is, we’ve demonstrated just how many options we actually have here at Calendar Options.