I trade a lot of 3-day Calendars. When I say ‘a lot’, I mean a lot! And, no, 3-day doesn’t refer to the duration of the trade, it refers to the difference between the long and short options. Specifically, the short option expires on a Friday and the long option expires on the following Monday which is 3 days later. The reason why I trade the 3-day Calendars in SPX is that, in almost every case, the implied volatility (IV) of the short option is greater than the IV of the long option. That means the Calendars are relatively cheap to buy. You know what other option structures are relatively cheap to buy? The Butterfly! In this post I’m going to compare both the 3-day Calendar and the Butterfly and I’m going to add my twist on the trade by making it a directional trade.
When testing a strategy the first place to start is by looking at an optimal time when the strategy should have performed well. If it didn’t perform well in the optimal setup then why waste my time testing it under sub-optimal conditions? Today’s test will be based on the recent past so this is a theoretical test and not an exact position that I traded. I can attest to it’s accuracy based on the thousands of times that I’ve actually traded both strategies over the years.
This was my tweet on May 4th while SPX was at 4063 and about 14 points off a potential double-bottom with the April 26th low. The day’s close was 4061 so IF I had wanted to trade a potential bullish resolution to a double-bottom setup I could have done that just prior to the day’s close. I can use the ThinkBack feature in ThinkorSwim to get those closing option prices.
Below is the price of a May12/15 SPX 4200 Call Calendar and a May12 SPX 4180/4200/4220 Call Butterfly. Why select such far out-of-the-money (OTM) strikes? Because they’re cheap! This isn’t a probability based trade, it is a directional trade! High probability trades are expensive and low probability trades are cheap and I want a cheap trade so that, IF I’m wrong about this being a double-bottom, I won’t lose much money as long as I keep my trade size small!
The Calendar cost $.73 ($73) and the Butterfly cost $.65 ($65). Cheap, right? How did they perform? The Calendar had a $142.50 profit and the Butterfly had a $145 profit. An approximate 200% return on each of them with the slight edge to the Butterfly.
Here’s where it get’s even more interesting! What if, instead of forming a double-bottom, SPX failed and price continued to drop sharply as it had the previous 3 days? Could I insure my position against that risk? If I had purchased a cheap, far OTM Put Calendar in the same May12/15 expiry as the Call Calendar then I would own a very wide Double Calendar for a total of $138. Take a look at how that combination performed.
I would’ve lost $42.50 on the Put Calendar insurance trade but would’ve still made the $142.50 on the Call Calendar. That’s a $100 net profit on a $138 cost basis for the Double Calendar. Not a bad return on a well-hedged position!
There are ways to reduce initial risk in these trades while holding onto a reduced size but these trades can also be exited for a nice 1-day profit. That’s up to each trader’s preferences. If you have questions about how they could potentially be hedged you can ask them down below. You should also experiment with other durations of these positions to see how they compare to this example. There are many posts on the blog discussing the 3-day Calendars as well as taking low probability trades for bigger profits. Take a look around! That’s all for today.
similar to the double calendar spread, can we place Call the BrokenWing butterfly spread hedge it with put Broken Wing Butterfly if it goes opposite? What are the ways to reduce the margin on Butterfly credit spreads
My general advice to any trader but especially those with a smaller account is to not hedge a Call Butterfly with a Put Butterfly or vice versa if price is not following thru as expected! Multiple trades increase your commission costs and make the positions quite complicated to manage. The simpler you keep your trading the better! Develop a plan based on what you expect price to do. I have *many* posts discussing how I analyze price action. If price moves as expected then look to Delta Hedge the trade to get to zero cost or better as soon as possible by rolling the strikes either up or down depending on the trade. Don’t try to hedge a position where price isn’t doing what you expected! If price doesn’t follow thru as expected exit the position with what should be just a small loss. *There’s always another trade!*