We’re again hedging our negative delta with another calendar spread above the market, as follows:
Day limit order
Buy to open 4 SPY Jun 140 calls
Sell to open 4 SPY May 140 calls
for a net debit of $0.66 or better.
Note that 4 contracts is our base position for single-strike calendar spreads. Trading whole-number multiples of the base-position size ensures that adjustments will not result in unbalanced positions. In addition, in order to come as close as possible to matching our Model Portfolio risk profile, it’s important to allocate an equal dollar amount to each initial opening trade in a cycle.
Analysis: The most important lesson I’ve learned in my years of trading options is Warren Buffet’s Rule #1: Never lose money (or at least do whatever it takes to minimize losses). This trade has negative theta, and thus reduces our profit potential—but it serves as an essential delta hedge to minimize our potential loss in the most challenging options cycle we’ve face since the start of backtesting for our latest strategy rules in September 2009.
Another important rule for traders is, “Never blame the market.” Certainly, the past two weeks’ rally, on the heels of the mid-March uptrend, has been extraordinary—but it would be a mistake to adjust our strategy for such unusual circumstances. Another classic kernel of wisdom is, “Don’t fight the tape.” Our solvency—and, ultimately, profitability—depends on hedging delta in accordance with market trends.
Our odds of reaping a profit this month have narrowed significantly, according to the mathematical models…but 1) Mean reversion is not dead; therefore, we may yet see a profit; and 2) Our strategy is to keep any loss to a fraction of average gains, and we’re still on track to meet that objective. Our new portfolio P/L curve is shown below:
This entry trade was chosen to fit our desired (positive-delta) risk profile. As gamma continues to increase approaching expiration, our next move will most likely be to reduce risk by starting to unwind our open positions.