Veteran subscribers have been here before, though not quite on this scale. Some confluence of outlier events near expiration—in this case, QE2 exuberance, followed by Euro-debt crisis, followed by anticipation of an Ireland bailout, a better than expected Philly Fed report and a successful GM stock sale—sends our calendar-spread portfolio into a tailspin. I’ve been reviewing the sequence of market moves that led to the November loss, as well as the actions we took in response, and will continue to do so in days to come.
A Better Bear Trap
One of the things that distinguishes the Condor Options and Calendar Options services from the bulk of options-education products out there is that we don’t just teach a strategy and demonstrate how we implement it—we also show members how and why we adapt our strategies to changing conditions and work to remove vulnerabilities. It’ll take me a week or so to develop and vet the latest round of improvements to help prevent big drawdowns, but here are my preliminary conclusions:
- We need a better whipsaw-filter rule – Failing to adjust ahead of the weekend before expiration week led to an irrecoverable loss in the gap down the following Monday;
- We should consider more effective vega-neutral (or negative-vega) hedging strategies – The strategy improvements we developed in April took steps in this direction, but even a theoretically vega-neutral vertical roll can prove damaging if the market reverses sharply, especially near expiration and especially when IV skews heavily toward short-term protection;
- The newsletter should continually remind members about appropriate allocation among strategies – My February 2010 post on risk allocation explained that calendar spreads have a lot more positive vega per dollar at risk than iron condors; therefore, it’s important to commit no more than half, and better yet, one-third (or less), of options-income capital to long-vega strategies.
Members can expect much more detail regarding all the above points in coming days and weeks. One hint of things to come bears mentioning sooner rather than later, though: I’m strongly leaning toward using negative-vega hedge trades like the November 12 put butterfly Bonus Trade as a regular component of our downside hedging strategy when risk-management action is triggered at a relatively high level of implied volatility. Butterflies are just condors with an overlapping short strike, so anyone who trades our iron condors newsletter shouldn’t have much trouble with this concept (and, of course, I’m available to answer any questions via e-mail). But before going ahead, I’d like to get a feeling for how comfortable members are with this idea (please send your comments to email@example.com).
The Good, the Bad and the Ugly
November’s Model Portfolio loss exceeded our target maximum, but not by much. Certainly this is a substantial setback, and the extraordinary sequence of events that led to it was as ugly as we’ve seen in our Calendar Options trading history. Nevertheless, our current strategy has the proven potential to return nearly 15% in one month and more than 40% in a quarter. Traders who drop an outperforming strategy whenever there’s a big loss ultimately will see nothing but losses; those who stay with the strategy (if it has a good long-term track record) have a history of recovering the loss and going on to greater gains.
I’m sure you’ve all had enough of my sermon by now, but we haven’t dealt with the real fire and brimstone until we’ve looked at the numbers:
- SPY November/December Double-Calendar #1 (Adjusted) – Closed for a 22.26% loss.
- SPY November/December Double-Calendar #2 (Adjusted) – Closed for a 28.16% loss.
- SPY November/December Double-Calendar #3 – Closed for a 9.70% loss.
Altogether, our Model Portfolio loss for November was 23.27%. But again, traders who sell options for income are more successful if they focus on long-term performance and use short-term losses to review their strategy for improvements.
Here and Now
Our current positions, likewise, have suffered from the recent volatility (and volatility of volatility, and volatility skew)—but this inning is far from over. Here’s where we stood at today’s close:
- SPY December/January Double-Calendar (120/126) – This position is trading at close to a 21% unrealized loss, with a delta of about 6% of capital at risk.
- SPY December/January Calendar Spread (118 Puts) – The above loss is tempered by the small (2%) paper loss on our second December position. The negative delta of this trade (less than 1% of dollars at risk) won’t provide much protection if the downtrend continues, however.
Our portfolio risk profile illustrates the growing downside risk, which, despite a fantastic-looking expiration profit curve, will have to be addressed if SPY falls much below $118…if we want to hedge against any possibility of incurring another significant loss, that is.
The status of our JNJ Supplemental Trades portfolio is covered in the analysis for this afternoon’s trade.