We are long the MAR/JUN 70 put calendar in DIA (Diamonds ETF) for a debit of $1.99.
More specifically, we are short the MAR 70 put and long the JUN 70 put. The risk of the trade is only the debit paid, which is $199 per contract. The way this trade works is that a though a debit is initially paid, premium is collected as the short front month option comes to expiration and is rolled into the next month. If the trade works out, each roll will generate a credit, the idea being that total rolls exceed the initial investment of $199.
Ideally, we want the Dow to trade around 7,000 at expiration in March, April and May. With the increase in volatility, that could generate individual roll credits in excess of $2.00 each. The plan, though is to pay for 50% to 75% of our initial debit with the first roll, completely pay for the debit with the second roll, and have the third roll on for free.
Short deltas. With our best case scenario being the Dow trading near 7,000, this trade is obviously bearish, which translates into short deltas in the options world.
Positive theta. Theta is time decay. We have it on our side with this trade because the value of our short front month option decays at a faster rate than the value of our back month long option.
Long vega. We like volatility increases with this trade. Long vol is like being long stock. You want it to go up to profit. If volatility increases, which it will likely do should the Dow retest November lows, we will get more credit for the rolls, because the option we are selling in a roll will be more expensive. Why will it be more expensive? Because grandma will start buying put insurance that’s why. And who cares what it costs, just get me some insurance! We will be glad to provide the service, for a small fee of course.
Calendars are ideally purchased during a suspect rally when volatility is decreasing. This makes them cheaper to purchase, and gives it more room to profit. For the trade to work, we do hold the belief that the current rally is suspect, a selloff is coming and volatility will increase.
Milktrader 
February 20, 2009 at 4:22 am |
Thanks so much for posting information on spread and paired trades. I’m trying to learn these, and there is precious little good information out there. This is exactly what I’ve been looking for — what the trade does, where it works, and when it’s a good idea.