A month ago we put on a trade in HD that looked to take advantage of the technical set-up to sell near term gamma to finance owning long vol in the next earnings month, December. With the stock at the sweet spot of this trade on the first day of expiration week I thought it would be a good time to go over how this trade sets-up for the rest of the week and what our thoughts are as far as managing it. I also like this structure being near its short strike because it is a good lesson on how options work on expiration week.
So let’s look at the original structure.
TRADE: HD ($76.54) Bought Nov / Dec 75 Put Calendar for 1.20
- Sold 1 Nov 75 Put at 1.10
- Bought 1 Dec 75 Put for 2.30
With the stock at 75 the trade is basically flat delta. Moves above 75 make the trade short delta and moves below 75 make the trade long delta. As we get closer to Friday those moves mean even quicker swings in the net delta. The reason for that is the expiring short put strike either becomes 0 or 100 deltas on Friday, a totally binary result, depending on where the stock closes. So today at 75.20 the put will show -45 deltas, but if that was 10 minutes before the close on Friday at the same exact spot in the stock, those puts would only be 5 deltas. And 10 minutes later they would be 0 deltas and expire worthless.
So that’s how that works. What’s happening simultaneously to the exponential acceleration of deltas is the chance of those deltas swinging to the other binary result, as represented in the extrinsic premium of that short option, is accelerating to zero as well. Right now, with the stock at 75, those puts are worth a little over 50c. Going back to the above or below 75 on Friday scenario, the value of that put will also be binary, it will either be worth something, or nothing. With the stock at 75, the 50c the put is trading for means that its entire value is currently extrinsic. If the stock was to go to 74.50 on Friday’s close, the put would still be worth 50c, but all of it would be intrinsic.
So all of that is a simple way to think about the greeks like delta, gamma, and theta. I mentioned that the decay of that extrinsic premium on the Nov put will accelerate into Friday’s close. The Nov option today has about 6c of decay, and the December option has about 2c. That December number will barely change this week, while that Nov number will increase rapidly. The other big greek that came into play on this trade is the vega of the Dec options. Part of the thinking behind this kind of calendar is that the earnings month option will stay bid as implied vol should rise in that month as earnings get closer. That’s exactly what’s happened recently in HD but it’s still not as high as it’s been in past cycles:
So enough of the learning, what are our plans for the structure? We’ll hold this one into Friday as long as the stock doesn’t break one way or another from the strike. The trade is currently worth about 1.60, but since there is still 40 or so cents of net decay potential left this week, we’ll be trying to squeeze a little extra out of the structure before making a decision to take it off entirely or hold the Dec options into earnings by possibly rolling the calendar or spreading the Dec 75 puts in the same expiration. We’ll update on the site when we make a move.