How to not get ruined with Options - Last post - Part 4b of 4 - Calendar and Hedge Trades.

In part 1 and 2, I explained the basics for options, in part 3a and 3b I explained simple and more advanced options strategies, but all of this does not help much without concrete examples. In part 4a, I explained some simple trades related to selling naked puts, covered calls, and debit and credit spreads. This last post is going over some calendar trades and some more advanced edge trades.

The calendars:

$HTZ: 108% in 6 weeks

This stock name may be a r/wsb meme, and the trade had some risk, but it was not a casino trade. It did not go as expected, but was still very profitable.

May 5: BUY +1 HTZ JUL 17 20 / JUN 19 20 1 PUT @ 0.07

Per contract - Max risk: $7 - Max profit: Around $25 to $30 (~400% of max risk)

Let’s explain the circumstances around the trade. Between March and May, Hertz dropped like a stone from $20 to $3 in 3 month. There were some talks that Hertz could be bankrupt, in which case the stock price could drop even lower, to eventually $0. Carl Icahn had a significant investment in Hertz, and the shortcomings in assets from Hertz important, but not too massive, so a white knight could potentially come and save the stock. Implied volatility was extremely high (around 400%). I got curious, looked at the numbers, and could not find anything to my liking. Sure, selling a naked put with a strike of $1 would give me a 50% profit of max risk ($0.35 premium, $0.65 risk). But given that I put a probability of 20% that HTZ would be bankrupt, and that the price would crash below $1, the profit risk profile was not good enough for my taste.

But then I saw that the June volatility was higher than the July volatility, and for the strike of $1, the puts were selling only at $0.05 difference. Hence the calendar trade. BUY JULY for $0.42, SELL JUNE for $0.35. I tried to buy at $0.05, then $0.06, nobody would bite so I had to raise to $0.07 to buy my contracts. Have to be patient.

The idea behind this calendar is that, at JUNE expiration, if the stock price is above $1, your short put expires worthless, and you can then sell your long put. Note that you don’t know exactly where the profit is going to be, as it depends on the final stock price and volatility. This could be a very profitable trade, but there is a non-zero chance that you could lose most of your contracts if the stock goes to $0, or jump to a high strike. To maximize profit, you want the stock to be as close to $1 as possible. In this kind of trade, you have to size it appropriately, and assume that you could lose everything, don’t cripple your portfolio if you are wrong!

Two weeks after the trade, HERTZ filed for bankruptcy. Ah shit! If it goes to $0, I lose the value in all my contracts. Stock dropped from $3 to around $1. Ok, I can still break even, or even make some money. Icahn sells his shares at $.72. Hmm, I guess he is not going to be the white knight. Still in the profitable range. Decided to sell half of my contracts for $0.15, so I would get back all my money at risk, the other half in the game is now pure profit.

June 1: SELL +1 HTZ JUL 17 20 / JUN 19 20 1 PUT @ 0.15

Profit of $8 per contract (114% of max risk)

Obviously, these contracts have small values, so you need a lot of them, which means that your trading fees are going to dampen your profit quite a bit.

June 4 to 8, stock shots up to $6. WTF! It happened that the white knights were Robin Hood noobs. Ok. At least it’s not $0, but that is going to reduce my potential profit. Dropped down to $2. Contract prices are hovering around $0.25 per share, good enough, we may not have more than that. Sold ¼ at $25 (350% of max risk), waited for the expiration and hoping for a price to drop further, short $1 puts expired worthless, sold my long put for $25 the next Monday (did not waste money on closing the short puts at least).

You can see how if you enter a calendar with the right setup, and low cost of entry, it can be quite forgiving in terms of profitability.

$DBO: TBD

Here is another trade that is interesting, it is not over, and is still playing out. The trade is going well, and it seems there is still some time to enter it, as the conditions are still similar.

June 305: BUY +1 DBO OCT 16 20 / JUL 17 20 7 PUT @ 0.45

Per contract - Max risk: $45 - Max profit: $50 to $100 (~150% of max risk)

DBO is tied to oil price, so it can be quite volatile. I maximize my profit as long as DBO stays around $7. If it drops significantly,then I will just get back to selling some puts (see post 4a). If it goes up significantly, then I will potentially break even, or even lose money. Because I have a bunch of oil stocks, I would benefit anyway.

I have a long PUT $7 for October, and short PUT in July, that I am going to rollover every month, until September expiration, and at that point I will sell what is left. I paid $45 per contract (money at risk), and I expect to get $20 to $25 per month (July, August, and September), plus the $20 to $25 left in my long October PUT.

We are past the JULY expiration, my short PUT expired worthless ($0.29 to $0.00). However, unsurprisingly, the DBO volatility dropped, so my long put dropped by the same amount from ($0.74 to $0.45). Which is why the conditions are still similar, except with a lower implied volatility, so that’s an even better setup, and I will probably increase my position on Monday.

I hope these examples show the value and power of calendars.

Advanced hedges

Now, let’s use all of what we have learned in these past posts to build some advanced edges. If you are familiar with r/financialindependence, you know that sequence of returns risk can significantly impact your retirement and withdrawal rate. You need bonds to compensate for that, but you also need a lot of equities for the long term. You can glide in and out of bonds, using a bond tent, so you can guarantee a 3-4% withdrawal rate for years to come (I know I am simplifying the picture here :) ).

What if you could build a portfolio that can give you 80% of the profit, and only 20% of the losses? That portfolio may not always give you the best profit, and it may not always be possible to be implemented cheaply, but this could help you reduce your sequence of returns risk. I actually used that strategy to increase my IRA portfolio by 20% in the past 6 months, while still being mostly long on SPY.

After the 2008 recession, I wanted to avoid that trauma again. I looked at diverse strategies, and I was trading options already. I ended up finding the SWAN portfolio. You can look up SWAN defined risk funds - And SWAN is the last name of the founders, it happens to rhyme with black swan! They have mutual funds - like SDRAX - but it should not be confused with the SWAN ETF which despite being similar is a different beast. So I started reading all their white papers, and from that reverse engineer their strategy. The short version is that they buy SPY, then buy a leap ATM put, and offset the cost of the leap by selling short term calls, plus some other trading. Their numbers were nice in sideways and down market, but they significantly trail in bull market, which is exactly what happened in the past 10 years.

I felt that their protection cost was too high. Buying a LEAP ATM PUT is really expensive, but their strategies aligned well with a strategy I was iterating on. Why would you buy a protection for SPY going to $0? Market is going generally up, a drop of 20% happens every few years, it can drop more by 30% to 40% but that’s not often. And 50% or more is once a decade.

What about we buy a protection for the most common risks? A protection between 20% to 30% drop. If it drops more, well, at least you will have avoided the first half of the drop, so you will still be ahead than most. What about we start the protection at a 5-10% drop. After dividends, I am fine losing 3-8%, when the market loses 20% or more.

We know how to buy a protection like that, it’s a vertical!

Let’s pick the strikes:

• Current price is $321.72

• We accept a drop of 8%, this means the protection starts at $295.

• We accept to protect against a 25% drop at most, this means the protection ends at $240.

BUY +1 SPY JUN 18 21 295/240 PUT @ 12.01

So for each share of $320, we can protect it between a drop of 8% to 25% for a price of $12.01. Knowing that the dividends will reduce the drop anyway. This protection will definitely help with most market drops and sequence of returns risk.

FWIW, the current ATM PUT $320 cost $29.65, 2.46 times our protection. Sure it protects against everything, but it comes at an expensive price (it costs 9.2%). Albeit imperfect, our protection costs 3.7%.

Now, how can we make this a tad better, so our protection does not cost as much as the money we have to withdraw every year? The expiration is June 2021, we are just after July 2020 expiration, which means we have 11 expirations in between. Let’s divide our protection cost by 11, i.e. $12.01 / 11 = $1.09. Now, if we sell a call contract or each 100 SPY shares for $1.09 every month, and we can roll it every month, and keep it OTM, these calls will have paid for our downside protection.

SELL -1 SPY AUG 21 20 342 CALL @ 1.14

Here, the strike of $342 gives us what we need, and a bit more to pay for trading fees. And it’s more than 6% away. Even if it expires ITM, we’ll have plenty of opportunities to roll out next month. This is similar to how you make money with a calendar (long position with a far expiration, offset by a short position with a short expiration), but the characteristics are completely different.

This position looks good on paper and in real life, but here are some words of caution, this can be a landmine if you don’t have a proper setup:

• Do not enter this position if the volatility is high!

  • Sure, right now, it seems to work but you have to sell a call for $1.09 every month to pay for the protection. What if the volatility drops in the coming year? Your $1.09 premium might not buy you 6% upside anymore, but maybe 2-3% or less.

• You will have a hard time if the market jumps up relentlessly!

  • You could be in a situation where you not only won’t profit from the upside because of the short calls, but your protection is losing money due to negative delta and theta.

• Do not enter this position after a sudden market drop!

  • You may kick yourself if the market dropped significantly and you did not have some hedge in place already, so maybe you decide to jump on this fancy trade. Well, this would be a huge mistake. You would be overpaying on your protection due to the sudden market drop, and when the market bounces back, you would not profit from it. If you entered this trade in mid-March 2020, you would have locked 20% loss or more. Enter this trade in times of peace.

• This position does not protect against multi-year back to back drops!

  • If you enter this position and successfully avoid a loss the first year, due to the elements above, you won’t be able to get it cheaply the second year. Although you reduced the biggest impact, it won’t be enough to protect against a 1929-style recession, with a multi-year drop totaling 90%. That being said, our current economic tools will probably prevent a 90% drop.

• You will have a hard time if the market dropped just after you entered the position!

  • You are at the weakest when you just entered the trade, because you just paid for the protection, but you did not sell many calls yet to offset the cost of your protection. Sure, you will earn money from the protection, but if the market bounces back months later, you would have lost on the premium (don’t sell a call after a market drop, unless you are ready for your shares to be assigned at that strike). This one is actually easier to mitigate, initiate ¼ of your contracts at a time, 3 months apart, that way you have your overall protection, and at any time you only have a few contracts that you just entered.

The best time to use this trade?

• When the market is at ATH, which usually coincides with lower volatility.

• You think that the market is over extended, and you are okay to potentially give up some upside in order to have some protection.

How did I get 20% return with this strategy on my IRA during the worst period of the past 10 years? And while still being mostly invested in SPY?

I entered the trade back in August 2019. It had appropriate entry points, but that was rough. Market kept going up and up and up, rolling my calls became harder, not offsetting much of the initial cost of my protection anymore. At the ATH in February, I probably was trailing SPY by 5%, with my short calls 5% or so ITM. I mean 13% up in 4 months, after going up 20% since the beginning of the year, really?!?

Anyway, I saw that Coronavirus was coming, and I was glad that my protection was still in place. The initial drop was covered by ITM short calls. All good, then it continued dropping to my loss zone, okay. Then it went below my lost zone where my protection became ITM. Because the protection is a vertical, it has a max profit. I sold my vertical puts at 80% and 90% of max profit, as I figured the market dropped too fast, and it could bounce back quickly. With the profit, I then directly bought high-beta stocks that were in a huge sale. Then the market bounced back. I still had my original SPY shares, plus a bunch of new shares, and no more protection.

What about collars?

Collars are much simpler to set up, but they usually are not an advantageous protection anymore, as since 2008, OTM puts are more expensive than OTM calls.

For example right now:

BUY +1 COLLAR SPY JUN 18 21 333/290 @ 0.08 CREDIT

You want the collar to cost you nothing, (we get $8 of cash back per contract here, close enough). Protection starts $290 (a 10% downside), however you give up any upside above $333 (a 3.5% upside!). Really?!? Not worth it.

You could decide to buy a vertical put instead of a straight put for protection. This is what the UJUL ETF (and alike) are doing. We saw that our earlier 295/240 JUN 2021 protection costs $12.01.

SELL -1 SPY JUN 18 21 349 CALL @ 12.24

A strike of $349 is a 8.5% upside cap over a year. Although, this is a much simpler trade, with a very predictable outcome between the two, you can see that the other strategy gives potential for a much higher upside cap, albeit with some potential headache before the final expiration. :)

Conclusion

This concludes my series about options. I hope they have been helpful. As you can see there are plenty of ways to play options, some very aggressive, some very conservative. These posts represent a 80% brain dump of my knowledge about options, the last 20% might take awhile and will be built with experience. I hope this will help you avoid significant and unexpected losses with options.

I wanted to thank everyone for the good comments, awards, and numerous PMs with words of encouragement, thanks and questions. Best of luck! Understand your risks, and stay safe!

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