We’re opening the following position for November expiration (note that we’re using calls at both strikes this time):
Day limit order
Buy to open 2 SPY Dec 121 calls
Sell to open 2 SPY Nov 121 calls
Buy to open 2 SPY Dec 117 calls
Sell to open 2 SPY Nov 117 calls
for a net debit of $2.13 or better.
Note, again, that 2 contracts per leg is our base-position size for double-calendars. Trading whole-number multiples of the base size ensures that adjustments will not result in unbalanced positions. Also note that matching our Model Portfolio risk profile requires a risk-based allocation strategy—i.e., putting an equal dollar amount into each initial position (prior to any adjustments).
Analysis: With this afternoon’s rally, SPY moved high enough to add to our portfolio in a manner consistent with our strategy of balancing risk-diversification versus our expectation of mean-reversion. The S&P has hit a level of major technical resistance and, as is typical after a relatively long, steep run-up, it’s starting to show signs of waning intermediate-term momentum (exactly why keeping some of our delta bias in the opposite direction is part of the Calendar Options strategy). If the Big Dogs decide it’s a good time to lock in some profit at the point where the train went off the rails in May, we’re staying on the right side of the market; and if the bulls manage to aim for the April highs, we’ll just keep buying calendar spreads above the market as volatility gets cheaper and cheaper.
As the P/L curve below shows, the expected probability of this position being profitable at November expiration is about 43%, and the trade is adding almost 6 deltas for each 2-lot unit traded. The 2.4-point negative skew between front- and back-month IV isn’t ideal, but it’s within our tolerance range. The reason for using a call spread on both ends today is that the negative skew at 117 is significantly greater in the puts than in the calls.
As long-time members know, however, we focus more on how trades affect our risk profile at the portfolio level, in proportion to total capital at risk. Our new portfolio risk curve has a delta per dollar of approximately –0.05% (assuming capital is allocated equally among positions), compared to something like –2.8% before this trade. Our net delta is still negative (slightly), but we also have the calendar-spread strategy’s inherent positive vega to offset price risk on the down side. (I’ve mentioned more than once the calendar spread’s usefulness as an all-in-one strategy for hedging both delta risk and volatility risk…but that’s for another time.)
[Post-market update: S&P futures are off almost half a percent after Apple and IBM reported better-than-expected third-quarter results, in what looks like a classic case of selling the news. That positive vega may start coming into play even sooner than expected.]