Why I Avoid Expiration Week

As I interact with options traders (mostly online), I see the topic of expiration come up quite a bit. I see lots of questions about what happens when options expire, especially in the money options. While I think it’s good to understand the terms and conditions of options contracts, I do not believe it’s usually worth putting oneself in the position where expiration is going to be a problem. In fact, I not only avoid expiration day I avoid expiration week and will explain why in this post.

Exceptions to the Rule

Before getting into why I don’t like expiration week, let me say that much of this has to do with how I trade. I’m not saying that every strategy, or even every successful strategy should never go to expiration. There are perfectly good strategies that expect to take contracts to expiration. One such strategy is known as the Wheel or I’ve seen it called Laddering. The idea is that you sell cash secured puts on shares you wouldn’t mind owning. Then if you get assigned, you sell covered calls against those shares at a price you already like. While this isn’t the way I trade, it’s a perfectly good options + stock strategy. But notice, I said “+ stock”. This strategy explicitly plans to own stock at some point in time. If a trading plan includes this, then going all the way to expiration is perfectly acceptable and, perhaps, even desirable.

Another example could be a vertical spread that is very far in the correct direction that going to expiration yields maximum profit and the risk of losing is very low. In this scenario, I would prefer a credit spread so that everything expires worthless and there is no assignment mess but it can work with a debit spread. While this carries a bit more risk than the wheel, it’s reasonable under these conditions to go to expiration.

There may be other exceptions to my rule but these are two off the top of my head. But now I’ll talk about why I don’t like expiration week.

What I Don’t Like About Expiration Week

If you’ve followed my trading videos at all, you know I like to trade non-directional spreads on large indexes (usually SPX). One of the many reasons I like doing this is that I don’t like picking direction and I don’t want shares (SPX is cash settled since there are no shares unlike SPY). There are occasions when I may trade an underlying that is share settled but, in any case, I have no desire for shares of stock in my options account. It’s just not part of my strategy. Because of this, expiration day and even expiration week cause more headaches than they are worth.

High Delta and Gamma

The main reason I don’t like expiration week with the types of trades I put on, it’s almost impossible to stay non-directional which is one of the main goals of my trading. I trade mostly calendars and butterflies which both have expiration graphs that look like tents. In fact, in my videos you’ll sometimes hear me refer to the tent of the trade. But for most of the trade, the T0 curve, which reflects today rather than expiration looks nothing like the tent. See an example below:

A 24-day Calendar on day 1

This is an example of a 24-day calendar which is a typical trade I’ve been doing recently. The shorts are 24 days away from expiration while the longs are 5 days away from the shorts. The dark blue “tent” is the expiration graph the light blue arch is the T0 line which represents the risk today. Note the difference between the two risk lines. As the trade gets closer to expiration day, the two lines will converge, slowly at first but very rapidly in the last few days. Note the slope of the T0 curve. It’s quite flat and manageable and I would consider this trade reasonably non-directional. And the Delta and Gamma values reflect this as they are both very low. As the underlying moves in either direction, the effect on the position is not very much, at least until you get outside the tend at which time the slope starts to get steeper. However I have a reasonable amount of time to manage the price risk as the tent covers about 2 standard deviations for 1 day. The odds of this trade staying in my tent in one day is around 94%. Not guaranteed to be sure but pretty good odds and even if it does go outside the tent in a day, the odds of not getting a chance to manage the trade is even lower. This is a pretty manageable trade, in my opinion.

Now let’s look at the first day of expiration week:

A 24-day calendar on day 20

So this is a theoretical view of that same calendar on day 20 (the Monday of expiration week). Now the change in the T0 line is much more apparent. On the one hand, the profit potential if the underlying stays in the tent is very good. At the center I can double my money. But look at the slope of that curve and the corresponding delta values. Delta gets very big, very quickly and moving much to either side of center can get this trade into trouble very quickly. This, to me, is no longer a non-directional trade once it moves even a few points from the strikes of the contracts. While the potential reward is great, the price risk is too high for me. Take a look on Thursday of expiration week:

A 24-day calendar 1 day to expiration

Now the two graphs are almost aligned which makes sense since expiration is 1 day away. But looks that the Delta values as you get away from the strikes. They get into triple digits very quickly. But also compare the corresponding Gamma values on the 3 charts. The high Delta change rate is driven by Gamma and Gamma is exploding during expiration week. This is why I refer to expiration week as “Gamma Week” because Gamma is driving the risk. Is there a big profit potential? Of course. But it all can vanish very quickly with a decent move and we still have another day in this trade before expiration.

Perhaps your thinking, well that’s just a calendar, what about a wide Iron Condor? Sure, you may get more room on a high-probability Iron Condor. But as expiration approaches, you run the risk of taking a max loss on the trade and the wider you make your Iron Condor the less credit received and the lower the reward for the risk being taken. Can they work? Sure. But you need the stomach for the end of the ride. For me, the risk/reward of wide Iron Condors is not attractive.

Assignment Is a Hassle

Just my opinion here, but dealing with assignment scenarios when I do not have the goal of buying/selling the stock is just not worth the hassle. As you saw in the above example, the risk/reward gets crazy but in addition to that, there can be assignment fees which can cut into the profits as well as tying up capital to squeeze out those last few dollars out of a trade. Taking all of that into considering, I’d just rather avoid it altogether.

Avoiding Assignment

Fortunately, avoiding assignment is relatively easy. Assuming the underlying is settled in shares, you can avoid assignment in almost all cases by doing the following:

Close Before Expiration

This is the most obvious one. Just don’t be there when expiration happens. Take most of your profit and move on to the next trade. If your position isn’t open, you can’t be assigned.

Be Aware of Dividends

While most underlyings are “American Style” which means they can be assigned at anytime before expiration, this rarely happens. The #1 reason this does happen is dividends. If the dividend is worth near or more than the extrinsic value on your short calls, there’s a good chance the shorts will get exercised and the shares will be called away at or near the ex-div date. The good news is that the dividend amount as well as the ex-div date are public knowledge, so with some planning, it’s easy to avoid this situation as well. Don’t have a short position on if there’s a reasonable chance someone would want to buy the shares to collect the dividend.

There are some rare cases that you can’t always anticipate. The only time I’ve had shares called away early was due to an acquisition. I sold some calls against some shares I owned and the company was bought by a larger competitor at a good premium. My shares were called away the very next day (it was announced after the market closed). In cases like these, there may not be much you can do to avoid early assignment. But fortunately, this is very rare.

What Do You Think?

So, this is why I don’t like being even close to expiration. It just doesn’t fit my style of trading. That doesn’t mean it’s wrong on all occasions, but I think it’s important to understand what can happen as trades enter Gamma Week. I see traders worry about what will happen to their trade if all or part of their trade expires in the money all the time. I agree it can be confusing, especially to newer traders. So unless your trading plan includes assignments, just avoid it. Thankfully, avoiding the various expiration scenarios is quite easy to do.

So, that’s my take. As usual I’m always interested to hear what my audience thinks. This is a place for learning and discussion options. So feel free to ask questions, make constructive comments, or start a discussion.

Until next time….Good Trading!

Trade Idea: A Narrow Calendar in a High Volatility Market

This market has been crazy for a couple of months now and this means that traders need to adapt to the conditions. I believe good traders can trade in almost any environment. A big part of my options journey is to learn how to trade in as many different market environments as possible. Only then can I consistently make money no matter what the market does.

As one who has only been trading consistently for about 5 years now this is, by far, the longest stretch I’ve ever seen with high market volatility. As many of you know I primarily trade SPX and my trading plans were built around normal volatility ranges with the VIX in the range of about 10-25. This market hasn’t been in this range since the start of the virus crash which is now been about 3 months. When it started, I did some of my usual alternative trades: trades on non-correlated things like metals, even doing some directional plays like synthetic covered call like I discussed in my last blog post. But this market is now in very new territory for me. VIX has settled down in the mid to upper 20s which is pretty low for the last 3 months but is still historically high. So what’s an SPX trader like myself to do? I usually don’t start going negative Vega trades like Butterflies until VIX is in the low 20s and forget calendars with their high positive Vega, right? Well…maybe not.

At least for now, a relatively low VIX is in the 20s. But that’s still pretty high. Calendars are tempting because volatility is relatively low compared to the last couple of months but it’s still high enough that calendars give you lots of room. But nothing is free in this market. The reason the market gives me a ton of room on calendars is because while a 25 VIX may feel low right now, it’s still quite high and so the risk of a big move is still around. Add in the fact that volatility is mean reverting and we could have the risk of dropping volatility while we’re very long Vega. That wide tent could contract and put the trade into trouble quicker. As I’ve stated in a previous blog post, when I set up my usual calendar in a low volatility market, I like to put my longs 2 weeks away from my shorts. This give me a nice mix of price and Vega exposure. The further out in time, the more expensive the calendar and the more Vega you get. This is because the longs will have more extrinsic value than the shorts so they will cost more and that extrinsic value will decay faster as the distance between them increases so you get more of a time difference and positive volatility exposure.

So how could a calendar be adapted to fit the market today? Here’s a modified setup that has been working well for more recently. I’ve named it a “narrow calendar” and it has the following differences from my standard calendar:

  • It is shorter in duration
  • The longs are very close to the shorts

To show some examples I need to set some guidelines. I could simply compare two calendars: one with 14 days between the shorts and the longs and one with three days. You will see a huge difference in the Greeks but I’m not this is a fair comparison because the risk is so much smaller. As you can see below:

An 11-day calendar with the longs 2 weeks out

This is an 11-day calendar with the longs 2 weeks from the shorts. The cost is $2291.30, I get very flat delta since it’s at the money and my Theta is 65 and my Vega is 106. Compare that with a one lot where I put the longs 3 days away and I get this:

An 11-day Calendar with the longs 3 days out

So you can see here, I have drastically less Theta and Vega but the cost is about 20% lower since the long is so much cheaper. This can be a benefit if you want to keep you risk down, but it’s not really a fair comparison with respect to the Greeks since they are proportional to size. So I think a fairer comparison is to make the narrow calendar a 5-lot to get similar risk size:

An 11-day Calendar with longs 3-days out (5-lot)

Now with a 5-lot the cost is $2306.50 which isn’t exactly the same but close enough that I think it’s a fairer comparison. The Vega is higher, but if you look at the ratio of Theta to Vega: it’s much better, almost 1:1. Yes, I have a bit more overall Vega risk but the Theta benefit more than makes up for it so my risk/reward ratio is better. And because this is a 5-lot, I’m able to scale this down to lower my risk while the first example is a 1-lot which can’t be scaled down.

So why wouldn’t I always do this style of calendar? The reason there is the volatility level of the market. I usually do calendars when VIX is under 13.5. In that environment, I don’t mind taking on more Vega risk relative to Theta because VIX is low and will most likely pop. But with VIX in the 25-30 range, I like to lower that ratio to help cushion the blow of a volatility drop. Also, when VIX is very low, I expect the size of the tent will be much narrower which will make this structure less appealing than it is now. So I would prefer to get more room by going back to a two week time spread.

Another thing to consider: with most underlyings you may only have Friday expirations so the shortest time you would have is one week. This is why I like doing this in SPX (or if you want to scale it down even more, you can use SPY), because it has Monday and Wednesday expirations so it’s possible to get very short distances between the shorts and the long.

Of course, I cannot say if this trade is right for you or not. Everyone’s experience level is different. If you aren’t familiar with spreads or calendars, you may want to paper trade a few to get the idea. Also feel free to check out my Options Fundamentals series where I try to explain these concepts in more detail for beginners. But it’s a good lesson in the Greeks and hopefully can spark some thinking about how to adapt a trade to different market conditions. If you would like to see how these trades have worked out, check out my This Week @MidwayTrades series around the end of May into early June. You can see my put these on and how I manage them.

As usual, I’d love to hear any feedback or questions on this or about options trading in general. Feel free to reach out here on the site or you can email me at midway@midwaytrades.com.

Stocks vs Options in a Volatile Market

At the time of this post, the market has incredibly volatile. Not only has volatility been extremely high, but it has stayed very high for weeks. In a normal market VIX in the 20’s would be considered high. Breaking 30 or 40 happens but it is usually quick and returns to normal. These are not normal times as VIX has been above 30 for about a month and over 60 for about 20 days. If you’ve followed the kind of trades I like to so via my video series “This Week @MidwayTrades”, you will understand that I’ve had to stop trading that way until things return to normal. I’ve been looking for different trades that I can try at a smaller scale while things are crazy. I think this is a good opportunity to show the power of options and how you can do very conservative trades while reducing your risk over stocks.

As with everything I do online, this is for educational purposes only, not trading or financial advice.

Thinking about Risk

Risk is on everyone’s mind right now but, in reality, it should always be on our minds. Managing risk is not just a trading skill but a life skill. But here on MidwayTrades I focus on trading skills. Every trade has risk whether with stocks or with options. With stocks, the primary risk is price, whether you are long or short, you have price risk in the opposite direction. In the world of options, we have more risk factors. Of course we have price risk, but we also have volatility risk, as well as time risk. (I’ll leave aside opportunity cost at this point, but that exists too). In the options world we use the “Greeks” to help describe the various risks to a position. My “Options Fundamentals” series covers these at a high level if you want to better understand them. But there’s a risk that’s ever more basic than the Greeks: How much can I lose in a trade? The most fundamental way to control risk is by knowing and limiting the total risk of a trade. This is done by the strategy deployed as well as the size of the position.

When I tell people I trade options, the first thing many say is “that’s too risky for me, I’ll stick with stocks”. While it is true that trading options can be quite risky, it’s all on how you set them up. I can create a position with options that is nearly identical to the risk of a stock trade for a fraction of the capital risk.

Long Options vs Stock

The simplest option position out there is simply being long a call or a put. This is the equivalent to being long or short a stock for a given amount of time. How equivalent? This is mostly dependent on which option you buy and it’s Delta. Very quickly Delta measures the price risk of an option if the underlying stock moves up 1 point. When you own a stock, your delta is 1. While this is technically impossible to match with an option we can get really close. The more in the money an option is, the more is will act like the stock. So a perfect at the money option will have a delta of .50 which means it will move up $.50 for every $1 the stock moves. As you go further in the money, the delta will increase until you get get 99%+ of the stock’s movement. Of course, the deeper you go in the money, the higher the cost of the contract. Also, the further you go out in time, the more expensive the contract. But this cost is generally still less than the cost of 100 shares of the stock, mostly due to the fact that it is time limited.

For example, let’s take a reasonably high priced stock like AAPL. Apple currently trades at about $284/share. So if I look out to June (65 days), I can get a .80 delta call for about $4,155. That’s a lot of money until you realize that a call represents 100 shares of stock and to own 100 shares of AAPL today would cost about $28,400. So the call is about 15% of the cost of the shares and it should move at about 80% of the stock. That’s not too bad. It also has similar risk on the downside where it will lose .80 for every dollar Apple stock loses. So the risk/reward ratio is much better and, I would argue, makes this a safer trade. If Apple goes to $0, the worst I can lose with my option is $4155, while with the stock I can lose $28,400. That’s a big difference!

Now, nothing is perfect, so if I’m going to pay 85% more for the shares, what am I getting for my money? Two things:

  • Time. This option expires in 65 days. At that point, it’s only value is the difference between Apple stock and $250 (the strike price of the call). If Apple doesn’t go up in those 65 days, I can lose money.
  • Dividends. Dividends go to owners of stock, not owners of calls. If you like a stock for the dividend, options are not your play.

So while you do give up some advantages of stock ownership, if you look at it from a risk/reward perspective, it may be worth it.

On the bearish side, the risk is not even close. To short a stock like Apple, a broker may require a good deal of margin in the account since the upside risk is unlimited. But if you a bearish on Apple, you can simply buy a put at any strike you wish. Because you long the put, there’s no extra margin worries but you are synthetically short Apple. Just like in the call scenario above, you can pick the strike (delta) and the amount of time, but it is far safer than shorting a high priced stock like AAPL.

Long Diagonals vs Covered Calls

One of the safest options strategies out there is the covered call. If you own 100 shares of a stock, you can sell a call against it to lower you cost basis. If the stock stays under the strike of your short call, you can keep the premium, and can sell another one later if you choose. If the price goes above your strike, you risk having your shares called away at the strike price. This usually only happens at expiration, but there are conditions where it can happen earlier (usually around a large dividend). This is a great strategy and many people use this as their first foray into the world of options (along with just buying a call or put). If done correctly, you can create a small income stream off of stocks you own even if the stock doesn’t pay a dividend. And each time you do this successfully you, essentially, lower the cost basis for your stock.

But as I showed above, owning 100 shares of stock can be expensive vs owning a deep in the money call far out in time. Buying such a call can act as a stock surrogate against which I can sell a call. This strategy is called a long diagonal but doing it in this manner is also sometimes called a “synthetic covered call” or a “poor man’s covered call” because it acts very similarly to a covered call without actually owning the stock. You may see other names for this strategy. Brian Overby of Ally Invest calls this a “Fig Leaf” because you are kind of covered.

So let’s compare these two strategies and compare the risk vs reward. Let’s use AAPL again as I think it shows well as an expensive underlying but this will work with any underlying. So in this example I have a standard covered call in AAPL. I bought 100 shares, and I’m selling a 300 May call against it (a .33 delta).

AAPL Covered Call. Risk: $13,575

This is a typical risk graph for a covered call. The total risk is the price of the 100 shares minus the premium received for the call. In this case that comes to $13,575. Pretty expensive, but AAPL is an expensive stock.

Now let’s compare that to buying a far out deep in the money call and selling the same call against it.

AAPL Diagonal. Risk: $5,980 (.80 delta)

The blue line is the original covered call. The green line is a long diagonal using a January 2021 $230 strike call (.80 delta). As you can see the risk graph is very similar but the total risk is significantly less at just under $6000. Now, the profit potential isn’t quite as good as the covered call, but this is primarily because the stock surrogate is an .80 delta while the stock has a delta of 1. While I think this is a good risk/reward, it’s possible to make the diagonal even closer to the covered call with respect to reward.

AAPL diagonal. Risk $10,190.50 (.93 delta)

In this case I bought a deeper in the money call: $180 strike with a delta of .93. This almost matches the reward of the covered call exactly. However, the risk of this trade is $10,190 which is much closer to the cost of the covered call than the .80 delta. This is why I prefer the risk/reward of the .80 delta, but the risk/reward ratio is really up to each trader.

Back to Risk

So, back to the risk of stocks vs options. In these example I have shown that in terms of real risk (the total amount that can be lost) options, using a conservative strategy and good risk management can be less risky than stock. Of course, there are valid reasons to own stock but I think it’s important, regardless of the vehicle, to understand the risk vs the reward of any trade or investment. Especially in times of market volatility, it’s good to have ways to reduce risk while still getting a good reward and options can be a way to do this.

As usual, I love to hear feedback on all of the content I create. Feel free to reach out here on the site or directly in email at midway@midwaytrades.com. How do you mange risk? Is this a strategy that makes sense? If you have questions, I’ll be glad to address them. I do this so that we can learn from each other.

Until next time …. Good Trading!

Midway Mail: Questions on My Calendar Setup

I always say I enjoy getting questions and fostering discussions and while I have been getting some very good feedback, I have found some questions that I think can be better answered in this forum than in email. I will keep the viewer anonymous, of course, but I think many traders out there could benefit from my answers and even come up with other (better?) ideas as well. I’m here to learn just as much as anyone so maybe someone out there has some better ideas and I’ll change my mind. All good stuff.

The viewer has some questions around the calendars I put on over the last few months. If you aren’t familiar with Calendars, check out Episode 13 my Options Fundamentals series. It should give you the basics of the trade and how it works.

Question 1: Why do my calendars more often than not start on the call side?

This is a great question and there isn’t one correct answer for everyone with respect to which side to use when setting up a calendar. When considering this, the first thing to determine is why you want to put a calendar on in the first place. This seems obvious, but I’ve seen lots of new traders put on trades without knowing why. There are traders who put on calendars to get a cheaper long call or put. They really want to be long a call or put but want to sell something against it to help pay for it. In this scenario, the ideal situation would be for the short to expire worthless leaving them with just a long call/put at a cheaper price since they got to keep the premium from the short option. In this case, it really matters which long option you want to have if the trade is successful. You really want to be directional, so you would choose the direction you want by choosing calls or puts.

However, that is not why I put on calendars. I am not a directional trader (outside of a rare speculation play) so for me, calls or puts isn’t nearly as important for my calendars. The reason I put on a calendar is that it is positive Theta and Vega and there times when I want those factors working in my favor. I almost always like Theta to be positive as I prefer time to work in my favor, but if the volatility of the underlying is low, I would rather be long volatility when trading it. I believe fundamentally that volatility is mean reverting, meaning that it always returns to the average. So when the volatility of my underlying is low, I would rather be long volatility since I believe it will go up. Conversely, when volatility is high, I like to be short volatility (negative Vega) since I believe it will go down. Of course, I cannot know how long it will take for this to happen, but the idea is to set up my trade to have the best chance to be helped by volatility. Since I also have time working in my favor, I can profit from that even if I don’t get the volatility move I expect, it just may take longer to get to my target profit.

Now that I’ve explained my goals of a calendar, I’ll try to (finally) answer the question. The answer is that, for me, it doesn’t really matter whether I start my standard at the money calendar in calls or puts. I intend to take it off as a spread so I’m not worried about which long I will have left. So how do I choose? I look at the open interest of the calls and puts that I intend to use and I pick the side that has the larger overall open interest.

So what is open interest? It’s a count of how many open positions exist on that particular option. It doesn’t matter if that open position is long or short so long as it’s open. This statistic gives us an idea of the liquidity of that particular option. The more open positions, the more interest there is in that particular option, the better the chance of getting good fill price with little to no slippage. Again, there are no guarantees here, but the idea is to put on a trade with as many factors in its favor to succeed. So if I have time on my side, potentially volatility on my side, and good liquidity so I’m not paying up for the position, I should have a better chance of success. Of course, price risk is always there as a calendar has risk on both sides as it’s a range-bound trade. But as I always say, this market pays me to take risk so there will always be risk somewhere.

So why did I end up choosing calls to start my position more often? Because during that time, the market was trending up which made calls more popular than puts. There could very easily be other times in the market when puts are more popular. So the preference for calls simply resulted from more open position in calls most likely caused by an upward moving market.

Let’s take a quick example. Let’s say I wanted to put on a calendar in SPX right now (note: I would not do that as volatility is too high, but this is just an example). I’ll do my usual shorts about 24 days out and my longs 14 days later (more on that later). Let’s look at the open Interest of each of my options:

Open Interest on shorts of a potential calendar

So, let’s assume I want to set up a calendar at the 3300 strike. So I choose 24 days for my short, and compare the open interest in the calls and puts. As you can see, the calls have a large advantage. But let’s also look at the options 14 days later.

Open Interest on the longs of potential calendar

So, in this case, the puts have a slight advantage over the calls. But it’s not enough to overcome the advantage of the shorts so I would start with calls here. It turns out today was a large up day so, again, it’s not surprising that the nearer term calls had such a large advantage.

None of this is to say that choosing the puts would be bad or wrong. Remember that using calls or puts doesn’t really matter to my calendar since I’m not worried about keeping the longs. And if I were to adjust the trade, I would most likely put on another set of calendars and I would use the puts for that to help keep my two calendars separate.

Question 2: Why are your calendars 2 weeks between the legs?

Another very good question and, again, there isn’t a perfect answer here. This has become a matter of preference for a couple of reasons. The first is this is the way I was originally taught to do the trade so there is some bias there. But, I keep doing it this way as I like the balance I get of risk and reward. All trades have risks and rewards and that ratio can be adjusted based on how the trade is entered.

As a quick reminder, a calendar is where I sell options and buy the same number of options at the same strike at some point later than the options I sold. It is this structure that gives the calendar it’s characteristics of being long Theta and long Vega. Why? A nearer term option has faster time decay than the same option further out in time. And in a calendar I am short the nearer term option so that is what gives me my time benefit (positive Theta). To get positive Vega, I buy my longs further out in time. Options further out in time have more volatility risk and since I am long the option that is further out in time, I get a positive Vega position.

So how does distance between the strikes affect the Greeks of the position? The further the distance in time between the legs, the greater the difference in the rate of time decay and so the result is more positive Theta. Similarly, the greater the distance in time between the legs, the greater the difference between the volatility risk and so the result is more positive Vega.

So why would I only choose 14 days? Surely, it would be better to increase the distance between the legs and get really high Theta and Vega working for me, right? Of course, there is no free lunch in this market and the price to be paid for having a large distance between the legs of a calendar is … price. In a calendar I am buying the further out option which has more extrinsic value (time and volatility) while being at same strike. This means that the greater the distance between the legs, the more the price of the longs will be compared to the shorts, which yields a higher debit for the trade which, in this trade, is my total risk. So I have to pay for the extra Theta and Vega with money from my account because the trade is more expensive. Let’s look at two examples:

A 24 day calendar with 1 week between legs

In this example, I have a simple calendar with the short 24 days out and the long 1 week later. This gives me 6.77 Theta and 46 Vega and will cost about $900. Now let’s push the long out to 6 weeks from the short:

A 24-day calendar with 6 weeks between legs

So this the exact same calendar but with the legs 6 weeks apart rather than 1 week apart. Here I get 32.84 in Theta, and 191 Vega which is much longer for both. But the cost of the trade is now $2726. So I have to spend about 3x more in capital to get the boost in Theta and Vega. That may look like a bargain, and there’s nothing wrong with taking that trade, but remember that Vega is a 2-way street. While it will be great if volatility goes up on this trade vs the 1-week trade however, if volatility goes down, I get hurt that much more as well. The other risk to consider is Gamma risk. While my deltas on these trades are similarly small, the Gamma is higher on the 2nd trade. While Gamma starts out small on both trades, the it will move Delta faster on the wider trade than the narrower one. This increases my price movement risk in a live market even though Delta starts off very neutral on both trades.

The Choices are Yours

I say all of this to say there is nothing bad about either trade as long as you, as the trader, understand the risks vs the rewards. There are many ways to set up a calendar to make these risk decisions. It’s up to the individual trader to decide what risks are worth taking versus the reward of the trade succeeding. A blog post is not the place to cover all of those possibilities but I did want to address the specific risks as it related to the questions asked. I hope this helped clarify what I’m doing as well as get you think about how to set up your trades.

Thank you again so much to the viewer who asked these questions. And I am very open to further questions or thoughts on anything on this site as well as trading in general. Feel free to follow-up here on the blog or reach out to me directly at midway@midwaytrades.com.

Until next time….. Good Trading!

Pets vs Cattle: My Biggest Trading Lesson

In the years I’ve been trading, I’ve learned many things. Of course, I started out with the mechanics of options, the Greeks, the strategies, etc. If you are interested in these fundamentals, check out my video series Options Fundamentals here on the the site or on my BitChute channel. I go over many of those early lessons about options trading.

But the craft of trading is more than just understanding the mechanics. Trading is also psychology. Paper trading is a useful tool, but you will never get the full experience until you are trading live money, your hard earned money. The ups and downs of the market become much more meaningful. It’s easy to get obsessed or stressed about your trades. The financial investment can lead to an even bigger emotional investment. Your idea is sound. Your plan will work. You have the skills to fix things when the market moves against you. You will make that profit. While confidence is certainly needed when one is in the risk management business (and that’s how I see options trading), you must be able to look at your trades as assets in your business. After all, what are options? They are simply contracts, a set of obligations that we exchange with others. They are derivatives of pieces of paper that represent ownership rights. Or in my case, as one who trades mainly the SPX, I trade a derivative of a derivative of pieces of paper which represent ownership rights

Why do I say all of this? Because recognizing this has helped lead me to the biggest lesson I’ve learned in trading so far. And the analogy I use is “Pets vs Cattle”. Bear with me for a bit and (I hope) it will all make sense.

If you have pets, as I do, you understand that they are more than just animal companions. To many of us, our pets are part of our family. We do our best to take care of them, feed them, get their shots, make sure they have the best life we can give them. When they get sick, we collectively spend billions of dollars a year getting them the best medical care we can. When they die, we mourn them. And, outside of truly obsessive behavior, all of that is perfectly fine and normal. We take in these animals, keep them in our homes and our lives and treat them and protect them as our own.

However…..

A farmer or rancher also has animals. He takes them in, feeds them, and protects them. But it’s very different. Those animals are not part of his family. His goal is to eventually sell these animals to make his living. If one of his animals gets sick, he is far less patient with medical care. Time and costs matter and he can’t let one sick cow infect the entire herd. While he may try some limited things to make that cow better, if that fails the cow must be put down and he moves on and focuses on the rest of the herd. To the rancher, the animals are a business asset. They exist to make him money to feed and protect his family (and his family’s pets). But he doesn’t have the emotional attachment to his cattle like he has with his pets.

So, let’s bring this back to trading. After learning the basics of trading, I struggled mightily with consistency. I knew how to win. But for ever few wins I’d get, one loss would wipe most, if not all, of those wins out. I just couldn’t get ahead and actually make any money that way. Losses happen in any business. You can’t avoid them. If you never lose, you never really took any risk and, as I said earlier, risk is how the options market pays traders.

So, I started critically reviewing my trades, especially the big losses. I needed to find what was common in my losses as well as what was common in my wins. And what I found was that when I would lose too much, most of the time I was holding onto a position too long trying to fix it and try make it profitable. I was adjusting my positions every time they went against me and was sticking with them stubbornly to try to make a bad trade work. In short, I was treating my trades like pets. I became emotionally attached to them. I knew if I just did more more adjustment, it would come back. This would go on until finally I was down so far that I finally gave up. A trade that I was trying to make a 10% profit was now down 35-40%. And when I tallied up my trades at the end of the month, it was those one or two bad losses that was the difference between a good month and a bad month.

I needed to change my attitude. I needed to see these trades for what they really were. My trades are my cattle. And like any herd of cattle, some won’t make it to market and that’s ultimately ok. But I can’t let one sick trade infect my account. Every trade takes up capital in my account. There are times when the best thing I can do is close the trade and re-deploy that capital into a new one that could be a winner.

So how am I applying this to the real world? First, before I put on a trade I always have a plan. That plan starts with the setup of the trade, the profit target, and the max loss. But the plan goes further. It also states what I will do when a trade moves against me. I have a plan for the upside as well as the downside. My plan then has the details for subsequent adjustments if needed. That’s all well and good, but I needed something more because just doing that wasn’t helping me avoid these bad losses. So I added some guidelines to my plan which I call my “Pets vs Cattle” rules to remind me of why I made them.

Guideline #1: I don’t adjust in the first 3-4 days. What I found was that when my trade went against me early and I started adjusting, I rarely made it back and it would have been better had I just closed the trade instead of adjusting at all. My trading style relies on Theta (time decay). Because I sell more extrinsic value than I buy, time works for me. But adjustments cost money, either by putting more cash or margin into the trade or taking a loss on part of the structure. So I’m sinking more capital into the trade to, essentially, buy more time for it to work. But if I do that very early in the trade, I haven’t really accumulated much time decay from which to draw. So I was digging myself into a deeper hole before realizing much Theta in the trade. And when I looked at the position at the first adjustment, it was usually a small loss or sometimes even a small gain or near break even. Here’s an example:

An example of a good loss.

So here I had my standard SPX 45-day butterfly. This shot was taken 3 days into the trade and I was already just outside of my butterfly tent. This is normally an adjustment point for me. But, instead I took the trade off for a loss of about $13 after expenses. On a $1300 trade, that’s about a 0.7% loss. Could I have adjusted here and saved it? Maybe. But if the trade goes against me this quickly, I’d rather just take it off and re-deploy the capital. Making up $13 on another trade is much easier than making up a max loss. This trade is cattle and I’d rather not sink more money into it if it’s not working early. Had this been day 5, I’d certainly consider adjusting, but not on day 3. (At 4 days, it’s a judgement call, thus the guidelines says 3-4 days).

Guideline #2: I consider taking off a trade that is at an adjustment point and up money. So assuming I’m past at or past the 4 day mark, if I’m at an adjustment point and up money, I could adjust it and try for more. But, more often than not, I’ll just take it off and re-deploy the capital. If the market gives you a profit, there’s nothing wrong with taking it. Generally if I’m up at least 4%, it’s a no-brainer to take it off. Less than that is when I’d consider adjusting since I’m getting close to break even.

Guideline #3. I limit the number of adjustments to around 4-5. Another observation I noticed in my bad losses was I was over-adjusting. This is somewhat related to the guideline #1 as adjusting too early can lead to over-adjusting. But as each adjustment costs money at some point I have to stop digging and move on. If I hit this limit, I take off the trade even if I’m not yet at my max loss. If I’ve adjusted 4-5 times in a trade, that’s a sign that the market conditions aren’t good for that particular trade and it’s best to take it off and either wait for things to calm down or put on a trade that is more conducive to the current market.

Ok, this blog would not be complete without an example of not following these rules so here it goes. On this trade back in 2018 (before I established my guidelines), I was doing an Iron Butterfly. My first adjustment came in day 2. I then went on to make 8 adjustments before taking a bad loss. Here is what the trade looked like on day 2 when I made my first adjustment

Bad Loss – Day 2

So, at this point, this trade isn’t in good shape. I’ve been in it for 2 days and I’m at an adjustment point and I’m $324 down or 11.5% on the trade. But I can fix it, right? I have an adjustment plan that will make this all better. Well, here’s what it looked like when I finally took it off after 7 more adjustments on day 15.

Bad loss after 8 adjustments in 15 days!

Ugh! I finally closed it for a loss of $1,145 or about 40%! So as bad as it may have felt to have lost $324 after 2 days. I’d take that over losing $820 more. But I was treating this trade like a pet, not cattle. Had I just cut my losses on day 2, I would have lost $324 but I could have re-deployed that capital and perhaps even made some or all of it back in the next 2 weeks. And it’s certainly easier to make up $325 than $1150.

So, hopefully, I’ve shown why a silly mantra of “Pets vs. Cattle” helped make me a better trader. I still say this to myself today whenever I’m tempted to break one of my guidelines. I put it in my trade notes when I close a trade early. This little phrase helps keep me from getting too attached to my trades. It reminds me to not get emotionally invested in my trades. Losses will happen and are ok as long as they are small losses. Maybe this can help you too.

As always, feel free to leave me feedback here on the site or reach out via email at midway@midwaytrades.com.

Good Trading!