Managing an Income-Generating Calendar

Let’s say that instead of trading a one-lot calendar, Richard trades it 20 times. His trade in this case is Sell 20 Bed Bath & Beyond January 57.50 calls at 1.30 Buy 20 Bed Bath & Beyond February 57.50 calls at 2.10 Net debit 0.80 His total cash outlay is $1,600 ($80 times 20). The greeks for this trade,listed in Exhibit 11.5, are also 20 times the size of those in Exhibit 11.3.Note that Richard has a 10.18 delta.

This means he’s long the equivalent of about 18 shares of stock—still pretty flat. A gamma of 20.72 means that if Bed Bath & Beyond moves $1 higher, his delta will be starting to get short; and if it moves $1 lower he will be longer, long 90 deltas.Richard can use the greeks to get a feel for how much the stock can move before negative gamma causes a loss.

If Bed Bath & Beyond starts trending in either direction, Richard may need to react. His plan is to cover his deltas to continue the position.Say that after one week Bed Bath & Beyond has dropped $1 to $56.50.Richard will have collected seven days of theta, which will have increased slightly from $18 per day to $20 per day. His average theta during that time is about $19, so Richard’s profit attributed to theta is about $133.With a big-enough move in either direction, Richard’s delta will start working against him.

Since he started with a delta of 10.18 on this 20-lot spread and a gamma of 20.72, one might think that his delta would increase to 0.90 with Bed Bath & Beyond a dollar lower (18 2 [20.072 3 1.00]).But because a week has passed, his delta would actually get somewhat more positive. The shorter-term call’s delta will get smaller (closer to zero) at a faster rate compared to the longer-term call because it has less time to expiration.

Thus, the positive delta of the long-term option begins to outweigh the negative delta of the short-term option as time passes.In this scenario, Richard would have almost broken even because what would be lost on stock price movement, is made up for by theta gains.Richard can sell about 100 shares of Bed Bath & Beyond to eliminate his
immediate directional risk and stem further delta losses. The good news is that if Bed Bath & Beyond declines more after this hedge, the profit from the short stock offsets losses from the long delta.

The bad news is that if BBBY rebounds, losses from the short stock offset gains from the long delta.After Richard’s hedge trade is executed, his delta would be zero. His other greeks remain unchanged. The idea is that if Bed Bath & Beyond stays at its new price level of $56.50, he reaps the benefits of theta increasing with time from $18 per day. Richard is accepting the new price level and any profits or losses that have occurred so far.

He simply adjusts his directional exposure to a zero delta.Rolling and Earning a “Free” Call Many traders who trade income-generating strategies are conservative. They are happy to sell low IV for the benefits afforded by low realized volatility.This is the problem-avoidance philosophy of trading. Due to risk aversion,it’s common to trade calendar spreads by buying the two-month option and selling the one-month option.

This can allow traders to avoid buying the calendar in earnings months, and it also means a shorter time horizon,signifying less time for something unwanted to happen.But there’s another school of thought among time-spread traders. There are some traders who prefer to buy a longer-term option—six months to a year—while selling a one-month option. Why? Because month after month,the trader can roll the short option to the next month.

This is a simple tactic that is used by market makers and other professional traders as well as savvy retail traders. Here’s how it works.XYZ stock is trading at $60 per share. A trader has a neutral outlook over the next six months and decides to buy a calendar. Assuming that July has 29 days until expiration and December has 180, the trader will take the following position:Sell 1 XYZ July 60 call at 1.45 Buy 1 XYZ December 60 call at 4.00 Initial debit 2.55

The initial debit here is 2.55. The goal is basically the same as for any time spread: collect theta without negative gamma spoiling the party. There is another goal in these trades as well: to roll the spread.At the end of month one, if the best-case scenario occurs and XYZ is sitting at $60 at July expiration, the July 60 call expires. The December 60 call will then be worth 3.60, assuming all else is held constant.

The positive theta of the short July call gives full benefits as the option goes from 1.45 to zero. The lower negative theta of the December call doesn’t bite into profits quite as much as the theta of a short-term call would.The profit after month one is 1.05. Profit is derived from the December call, worth 3.60 at July expiry, minus the 2.55 initial spread debit. This works out to about a 41 percent return.