With the January put vertical spread closed, we have enough margin available to open the following position for February expiration:
Day limit order
Buy to open 2 SPY Mar 131 calls
Sell to open 2 SPY Feb 131 calls
Buy to open 2 SPY Mar 125 puts
ell to open 2 SPY Feb 125 puts
for a net debit of $2.40 or better.
Note that 2 contracts is our base position for double-calendars. 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 equal risk to each initial opening trade in a cycle. (Hedge positions may vary).
Analysis: We start thinking about entering calendar trades about six weeks before front-month expiration, and that puts us just inside the time window for opening our first February position. And with implied volatility back down around six-month lows, there’s no reason for delay. Although theta is relatively small this early in the cycle, getting an early start nevertheless allows more room to accumulate a little profit from time-decay while gamma is tame.
Another reason we’re eager to open a February position is that Jan/Feb volatility skew has been stacked against long calendar trades. We’ve successfully dealt with that 2- to 3-point back-month skew by favoring low- and negative-vega strategies, but I’m sure members will be glad when we can get away from double-diagonals and focus on using straight calendars and double-calendars for our core positions.
Average implied volatility for February SPY options is still two points below the March average (those are the IV numbers given in the analysis table)—not great for buying an at-the-money single-calendar—but the IV difference at the double-calendar strikes we’re actually using for this trade averages only about 1-1/4 points. Remember, our objective isn’t so much to take advantage of forward vol skew as it is to profit from the difference in time-decay between options that expire in different months—while keeping volatility risk at a reasonable level.
So here we are, kicking off the February cycle with a plain-vanilla double-calendar, just the way the strategy is supposed to work, when volatility isn’t at crisis levels. We choose strikes far enough apart to spread out risk, and close together enough to provide sufficient profit potential at the center dip in the expiration P/L curve to overcome any loss we’re likely to take from a drop in back-month implied volatility. Our initial delta bias is slightly bullish, and this trade has quite manageable vega (just over 4%). The anticipated probability of this trade being profitable at February expiration is a healthy 43%.
Note that the risk profile and analysis above are for this new position alone. I went back and forth numerous times trying to decide whether to manage risk at the portfolio level, like we do for our collective positions with the same expiration cycle, or to keep trades expiring at different times apart. Looking down from the 10,000-foot level, overlapping time frames is just another way we spread out risk within the same portfolio—but the current risk profile of this trade has such a small effect on our total risk compared to the January positions, that I decided it would just confuse matters to merge them together.
So we now have two “portfolios”, for the time-being, with different anticipated risk-management price thresholds. This Feb/Mar trade can tolerate a range of price movement on the order of ±3%; the January portfolio would require attention if SPY strays just 2% from the mid-point between adjustment levels. I’ll have more details about the status of our January trades in the next post.