In another month of fast-moving, trending price action—one of the two worst scenarios for the Calendar Options strategy (the other being a plunge in implied volatility)—we were able to come away with only a small average loss. We played it cautiously from the beginning, expecting the resumption of the bear market to keep price volatility high throughout the cycle. Consequently, we entered just two trades for July.
We had to make one adjustment by the time July rolled around, but both of our positions remained quite manageable—until the latest chapter in the credit crisis story hit. As fears of a banking meltdown grew, we made risk management our number one priority and closed both positions. Even though our two trades averaged a loss of 1.71%, we managed to beat the S&P 500 once again.
Performance comparison
Market performance for the past month:
- S&P 500: −4.47%
- Dow Jones Industrials: 0.38%
- Russell 2000: −4.71%
- S&P Covered Call Fund: −8.26%
- Calendar Options: −1.71%
Note: The time period measured is from expiration to expiration.
July Calendar Spreads
- EEM July/Sept 140 Calendar Spread: −9.42% return – We opened this position once it looked like EEM had found support around $138, where it had consolidated in April on its way up. Two days later, the ETF broke down, closing off $4.63—more than twice EEM’s one-day standard deviation. We were able to keep pace with the sell-off by making two adjustments, and in a “normal” month, we would’ve kept this trade going into expiration week and rolled our short options out to the following month. But as the Friday before expiration week unfolded, it looked like one of two things would happen Monday morning: Either concerns over Fannie, Freddie, and Indy would drag the market into the abyss, or a government bailout would cause a sharp rebound. With expiration-week gamma risk looming, the only reasonable play was to punt.
- IYR July/Aug 61 Calendar Spread: 6% return – Part of our thesis when we entered this trade was that although ongoing worries about the economy probably would pull IYR down with the overall market, the real-estate bubble had burst long ago, and there was little likelihood of any more surprises particular to this sector. Then investors woke up to the fact that if Fannie Mae and Freddie Mac were to become insolvent, credit might lock up so tight that real estate transactions, not to mention new development, could come to a screeching halt. We held on through one adjustment and the subsequent whipsaw, but you don’t ride a calendar spread into expiration week on the heels of two 3.5-σ days. Sound risk management dictated that we close the position immediately.
July Reading
We published only one general, strategy-oriented Calendar Options post during the July cycle, but it’s one that any trader who wants to learn the strategy should read:
Another, older post we recommend reading (or rereading) in conjunction with this Monthly Review is our explanation of How We Calculate Returns. Because we adjust our trades, and adjustments often involve rolling a fraction of our position, it’s not intuitively obvious how, for example, we could have opened our July IYR calendar spread for a net debit of $1.15 per share and closed it for a net credit of $1.325 per share, yet have a profit of only 6%, as shown in the Calendar Options table on our Performance page. Understanding the actual performance of the strategy is another must for anyone interested in following Calendar Options.
Looking Ahead
Implied volatilities are still running higher than we like for buying calendar spreads, and it’s already less than 25 days to August expiration. Under the circumstances, we might not get a good chance to enter a Calendar Options position this month. We can’t realize the returns that probability predicts for our strategy over the long-run if we let last month’s volatility and losses prevent us from trading the next month, and the next, and the next—but that’s not what we’re doing. In this case, we’re merely exercising discipline by following the rules of our strategy, which dictate that we enter a trade only when the implied volatility of the options is decidedly below the middle of its 12-month range. Despite the fact that the VIX has dropped more than 30% since its July 15 peak, the options on our Calendar Options short-list are still overpriced.
When risk is running high, it’s important to remember that missed opportunities are easier to make up than losses on bad trades.