Since it was a quiet overnight session, with not much new to note, I want to take a detour from the macro this morning to focus on some trade school.
We use calendar spreads very frequently on the site because of the pernicious nature of time decay in options. It sounds nice in words, but I want to walk through a trade example to illustrate just how valuable calendar spreads can be, rather than just buying outright calls or puts to express a bullish or bearish view.
In late October, Abbott Labs (ABT) had a severe decline on bad earnings and drug-related news. Here is the 1 year chart:
The stock broke its very steady uptrend for the year on the decline, breaking the 50 day ma (purple line), and nearing the 200 day ma (black line). On Oct 23rd, I decided to initiate a bullish bet with the stock around $65 (date circled in red). I bought the Feb 65 call / Dec 67.5 call diagonal.
In that piece, I wrote the following in my trade rationale:
I chose the Feb13 at-the-money strike for my long because ABT reports earnings before Feb expiry, so implied volatility should not move much lower from here. Meanwhile, given the strong selloff in ABT on big volume in the past week, I think the 67.5 level (around the 50 day moving average) will not be regained for some time. With this structure, the short December 67.5 call will decay much quicker than the long Feb13 65 call, and so I can wait patiently for an eventual anticipated turn higher on the next market bounce.
Since initiation, ABT stock is basically flat. In reality, it has disappointed my expectations on the most recent market bounce, struggling to regain the $65 level where I first put the trade on. BUT, the trade structure has saved me significant pain. I bought the call diagonal for $1.50, paying $2.23 for the Feb 65 calls, and selling the Dec 67.5 calls at $0.71. Today, the Feb 65 calls are worth $1.68, while the Dec 67.5 calls are worth $0.12.
If I had bought the Feb 65 calls outright, I’d be down $0.55 on the trade. Instead, I’m up $0.06 since the Dec decayed at an even faster rate.
These sorts of calendar structures are ideal in situations where you don’t expect a large near-term move, but want to give yourself the bullish or bearish exposure in the interim.
In this case, I have become more exposed on my long Feb 65 call position as the Dec 67.5 calls are close to worthless. Also, ABT has not bounced as much as I had hoped on this rally. So I’m likely taking this position off in the next day or two. Risk is greater, and my original thesis has not held.
Markets overnight:
- Asia followed the U.S. into the green again, with almost all markets higher there, between 0.25 and 1.25%. Japan approved $10 bln in additional stimulus (and yen 2% from lows of the year) ahead of their elections mid-December
- Europe opened red, but quickly rallied into green, though very tight range. It is up 0.25%, as are SPX futures, which also traded in a tight range.
- The dollar and Treasury bonds are slightly lower, while commodities are slightly higher.
- Personal income and spending data at 8:30 am the main release today.