This post is about the smaller account that I manage for somebody. The positions are smaller and easier to understand than my positions which don’t seem that helpful for demonstrating good trading techniques! 😄 On twitter I refer to it as the PDT account. PDT is short for Pattern Day Trader and if you don’t know what that is, it probably means you have a larger account. Good for you! For those traders who do have to deal with PDT rules, they know that trading options can present some challenges since you can only make 3 ‘day trades’ within 5 business days. There are ways to deal with that issue and I’ve mentioned in the twitter feed that /ES futures options can be used to hedge a SPX position and PDT rules do not apply to futures options. There’s also another way the directional risk of a SPX trade can be hedged without triggering a day trade. The side benefit is that you can also learn how to hedge your time/expiry risk. What is time risk? Have you ever had an options position on and you got the direction right but your position’s options expired before price made the target? That’s time risk! We can minimize time risk by having positions in multiple expiry’s. Below is the current position in the PDT account. Not a bad position; lots of room to both the upside and the downside, lots of Theta but also a fairly large amount of Vega. The position is also short 13 Deltas. That’s good if SPX goes lower but if SPX rally’s instead then the position will lose on the short Deltas and, if VIX goes down as it typically does if SPX rally’s, the position will lose value there also. Based on my current chart analysis I expect SPX to rally in the very short term. Let’s see what the time risk looks like.
Below is the risk profile showing only the Sep30/Oct3 positions. Obviously that position needs a move lower in SPX to get anywhere near the maximum potential profit. Let’s consider an example for purposes of understanding a potential solution for time risk and for the issue of trying to limit day trades. Let’s say that I just bot this Double Calendar on a Monday morning and then price made a bullish reversal or a failed breakdown and I now think that SPX may first rally for a day or two before resuming it’s downtrend. If I exit this trade on the same day I bought it then I trigger a day trade. Also, this isn’t a bad position since I expect the larger trend to take price lower but over the next day or two I need some upside protection. Instead of exiting that trade, enter the time risk adjustment!
Below is the risk profile showing a Sep23/26 Double Calendar. Remember, we’re pretending I didn’t already own this position and I would use it as a trade to hedge the time and Delta risk of the Sep30/Oct3 bearish position. I could have bought this on the same day that I bought Sep30/Oct3 Double Calendar without triggering a day trade. This would generate plenty of Theta and would be a Delta neutral trade. The weak point of this trade is that it’s also long Vega so a drop in the VIX would reduce the profitability of the position. This trade could be called an under-hedge. There’s a FOMC announcement on Wednesday of this coming week and I’m expecting, even if SPX rally’s, that the VIX will stay bid at least through Wednesday morning which is when it’s quite possible I’ll exit the Sep30/Oct3 position unless SPX is near the middle of the spread around 3850.
You could easily second-guess me and say that a better upside hedge if I’m expecting a SPX rally over the next day or two would be a Vertical Call spread or maybe even a Broken Wing Butterfly. I couldn’t really disagree with you there. That would be a perfectly fine way to hedge for a rally. Since I’m expecting VIX to not drop much or perhaps even climb into Wednesday morning I’m okay with holding the Sep23/Sep26 Double Calendars for now. However, if you’d like to see what the overall position would look like if I hedged it to completely flatten the Delta risk and open up some upside profit potential, see the risk profile below. I could also use /ES Call Verticals instead of SPX just in case I want to exit those on the same day that I bought them. 🤔
Questions or comments? Leave them down below!
So the hedge for a temporary rally after which you expect the trend continuation lower is to get something like Theta > Vega + [Delta] ? The more so the better?
And the Sept26/23 PUT spreads have no Delta bias because the long and short strikes are the same, and the IV (implied volatility) is dampened by the fact there are only 3 days between the two expirys but the Saturday and Sunday of those days are not tradeable and prevent any change in IV? But the fact that the weekend sits between the two expirys forces the Theta to be high?
Not necessarily. Theta is always better than Delta/Vega over the *long-term* but since I’m a directional trader at trade entry I don’t mind when Delta/Vega far exceeds Theta prior to a DH trade. In the case of a Delta adjustment because I think price is temporarily heading in the opposite direction that I’m positioned for I’ll often buy ATM Calls which adds to the Vega but the LARGE Deltas more than offset that and then I *quickly* look to roll into either a Vertical spread or a BWB to bring the Delta/Vega back down and inject Theta into the position.
The Fri/Mon Calendars are *very cheap* to buy because the Friday options are typically higher IV than the following Monday. That’s the ‘edge’ in trading those and why I use them extensively for time spreads. The don’t have a lot of Delta risk unless they are far OTM so if you buy them 2-3 week’s out they’re ridiculously cheap and have a very good potential reward/risk. They are some of the most forgiving option structures that you can choose! I generally prefer to initiate them as Diagonals and roll them into Calendars.
Paul, given that you have two different double calendars described above, could you confirm what you intended when you said, “I’ll exit the Sep30/Oct3 position unless SPX is near the middle of the spread around 3850.” Did you intend:
A) Exit the Sep23/Sep26 unless SPX is in the middle of the spread around 3850
B) Exit the Sep30/Oct3 unless SPX is in the middle of the spread around 3750
Thanks!
Yes, “A” is what I meant. Thanks for picking up on that!