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Understanding Calendar Spreads and How They Work Pt. 2 — Transcript

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0:05we're going to be having our man Dan
0:07here covering calendar spreads part two
0:09he's going to give us a brief on the
0:12Delta Greek and how it functions within
0:15calendar spreads today we're going to
0:18talk about uh so we're in the context of
0:20the of the put calendar spread uh
0:23structure right we're on part two and
0:25what we're going to talk about is the
0:27Delta associated with a put calendar
0:30spread or a call calendar spread because
0:33they both uh they're they're both going
0:35to work the same way um they're just the
0:40the put calendar spread uh as described
0:43in this presentation is going to be
0:46situated below the spot price and a you
0:50know your your call analog is going to
0:52be situated above uh above spot price in
0:56my kind of crude interactive Delta graph
0:59example uh I picked calls because I just
1:02uh I just love variety and when we're
1:04talking about the put side uh there are
1:07some more interesting implied volatility
1:10effects uh that will cover uh that will
1:13cover I'm sure in like part three and
1:15part four when we talk about implied
1:17volatility and and Vega inside put
1:20calendar spread today we're we're
1:22talking about Delta the the hint of
1:26delta in this in this trade from my my
1:30summary slide from last week is when I
1:32mentioned that calendar that out of- the
1:34money calendar spreads like we're
1:36talking about here are positive gamma
1:40when I say A put calendar has positive
1:43gamma this positive gamma is implying
1:47that we are net long options even though
1:50we sold one and we and we bought one the
1:54extra time that we have by buying the
1:57further dated uh the further dat
2:00option protects us from some of the
2:04nastier effects that are associated with
2:07having uh short options on your on your
2:11book so the fact that these are positive
2:14gamma means that a directional move in
2:17your favor um is going to increase the
2:21Delta of your overall position more
2:25rapidly so the interesting thing about
2:29deltas
2:30excuse me about Delta in the context of
2:32a put calendar is that when when we're
2:35trading them in this out of the- money
2:36fashion the absolute value of the Delta
2:40is going to grow and grow and grow until
2:43you get to the actual strike until you
2:47get to the strike price um you know the
2:49one that you the one that you you sold
2:52one and bought the other so so if price
2:54is moving in your direction and it
2:55finally and price finally gets there
2:58that's where you're going to reach the
2:59the maximum absolute value of delta and
3:03I'm sorry to be bringing up math terms
3:06in this way but technically Delta is
3:09negative um on a uh on on puts because
3:14uh because in this particular structure
3:16the value uh is going to increase when
3:20price of the underlying goes down right
3:22so you have you have negative Delta is
3:24what that means and
3:27in in favor of not
3:31being uh confusing math wise and saying
3:33something gets more negative because
3:35that generally means like small smaller
3:37even though it's a good thing in this
3:38case I just say the absolute value of
3:40the Delta is going to continue to grow
3:43now what's interesting about a calendar
3:44is that at a certain point if price
3:47keeps on moving in your direction maybe
3:50it moves a little too far in your
3:52direction if you know you know what I
3:54mean it goes past your strike the the
3:57Delta can actually flip uh and it can um
4:01you know it can go from negative to
4:03positive uh if it's on the call side it
4:05can go It Go from positive uh to
4:07negative this doesn't I promise you you
4:10might hear that and think well it's
4:12going to blow up my position it's going
4:13to go to negative whatever and I'm gonna
4:16lose a bunch of money that's not that's
4:17not how it goes it's just a the result
4:20of like both strikes being in the money
4:24but um the front one is closer to
4:26expiration so that one is more like ly
4:30to expire in the in the money uh has the
4:33absolute value of that short dated
4:36contract has now gotten larger than the
4:39back data one but long and short of it
4:42is that for most of the life of this of
4:45this trade this put calendar spread
4:48you're going to have negative deltas and
4:51the the absolute value of those negative
4:53Deltas is going to is going to increase
4:55as the underlying price moves in your
4:57direction and that actually leads us
5:00into just a general review of Delta
5:04which I think is a good refresher for
5:06everybody every now and again so the the
5:11definition of delta is the change in an
5:13options price called premium due to the
5:18change in the underlying security
5:21price in
5:24equities this is typically expressed as
5:26a decimal okay so in your brokerage
5:29software you'll see uh like something
5:32like
5:330.25 uh for a uh 0.25 Delta um call or
5:39put uh
5:42but as as you know when you're like
5:45speaking about this like when you're
5:47when you're talking with somebody it's
5:49not uncommon to hear uh to hear them
5:51expressed as like the full whole number
5:54so you might describe uh a
5:570.25 Delta option as 25 5 Delta um just
6:01know that uh this very very common and
6:04it's the difference between um like
6:05speaking and writing I think it's a lot
6:07more common in writing to see 0.25
6:11describing the Delta but in conversation
6:14someone would probably describe it as 25
6:16Delta uh
6:18option the standard Equity multiplier
6:21for an option is 100 so we say cedus
6:24parabus which means everything else all
6:26else equal if the stock price like
6:29teleports in 0 seconds down
6:34$1 then a minus .25 Delta put right I
6:39would call that like a like a 25 Delta
6:41put we'll see its premium increase by
6:45$25 okay you have a $1 you know minus1
6:51doll price change times minus 0.25 which
6:55is our Delta times the standard 100
6:58Equity uh multiplier for Equity options
7:01and that equals uh
7:03$25 and the the intuitive way to uh talk
7:08about Delta is uh in terms of like like
7:13share equivalent um or you know what it
7:16like like what it feels like to own to
7:19own that that number of shares so the
7:22share equivalent of a uh a 25 Delta put
7:26which is going to be negative is going
7:28to is going to feel
7:30like being short 25 shares of stock XYZ
7:35because if stock XYZ if you if you were
7:38short 25 shares of stock XYZ and the
7:41price of XYZ uh went down by
7:44$1 your your p&l your profit and loss
7:48would would be plus $25 you would you
7:51would have unrealized gain of $25 and
7:54that's exactly uh cus parabus what would
7:57happen with a a 20 5 Delta put as well
8:02if the price drops by
8:04$1 then your the option value uh the
8:09premium associated with that option
8:11would be uh would be $25 higher because
8:15the price has moved $1 in your direction
8:18and it was a 25 Delta option but when we
8:21talk about when we talk about Gamma
8:23we'll know that okay now that the price
8:25has moved down now it's like now it has
8:27a bigger Delta value so the next dollar
8:30move in your direction is going to be
8:32even it's going to be even larger right
8:34and that's um you know that's uh that
8:36has to do with with what we would say is
8:39convexity and why uh long long options
8:43long calls and long puts uh can have
8:46such a can have such a handsome reward
8:50uh profile when when price moves in your
8:53direction very quickly and so the one
8:57the one last thing that I just wanted to
8:59to Riff on briefly for Delta is uh is
9:05something that I hear uh now again and
9:09like like some some people would say
9:11that Delta is the probability of the the
9:15option in question um expiring in the
9:19money and uh I I don't think that's
9:22actually I don't think that's true like
9:24if we were to do an empirical study and
9:26we were to look at all the the 10 Delta
9:30calls and the 10 Delta puts I I suspect
9:34that those wouldn't finish in the money
9:3610% of the time right like I I don't
9:39think I think that's a I think that's a
9:42that's a good heuristic when you're
9:43talking about the at the money call or
9:45the at the money put because the at the
9:47money call or at the money put is
9:49typically around 50 Delta and that makes
9:54uh that makes logical sense right you
9:55have an you have an at the money
9:57contract it's like 5050 you don't you
10:00know 50/50 chance is the price going to
10:02go up one penny or down one penny and
10:04your and your uh option will finish in
10:06the money like buy one penny or out of
10:09the money buy one penny right like that
10:11that makes sense um if you think you
10:14know if you're if you're being a real
10:17first principls um student of this stuff
10:21the the at the money Delta 50 that makes
10:24sense right there's like a 50-50 chance
10:26that option finishes in the money if it
10:29EXP fires in the next one second or or
10:31whatever like that but um towards the
10:35the tals right at the extremes I think
10:38that uh probability of finishing in the
10:40money I think it's um uh I'm not I'm not
10:43sure that necessarily would uh would
10:45hold true right I think it's better to
10:47just um focus on focus on Delta as like
10:51your your underlying price payoff um
10:55multiple for uh for for a given trade
10:59you'll recall if you watched our review
11:01from last week uh this slide was on here
11:04uh and and I wanted to show this this
11:06slide again really quick here because it
11:08animates uh what the p&l difference is
11:10for a foot calendar spread as time goes
11:14by so when when the trade starts there's
11:19like a like a lower like a like tent
11:22kind of section here and as time goes on
11:25the The Profit will become uh
11:27potentially quite large right at the
11:30strike uh that you that you sold and
11:32bought over those different times and so
11:36the last thing I want to touch on when I
11:38say that a that a calendar spread that's
11:41designed in this way has um convexity
11:46what I what I mean by Delta convexity is
11:48that over time as we get closer to
11:51expiration moves in the underlying are
11:55going to have a a more drastic uh Delta
12:00change on a calendar spread and so what
12:05you're looking at right here is my um
12:08like a like a crude illustration of that
12:11um you know be gentle be gentle it's
12:13like it's you know I'm not a a
12:16professional programmer by any stretch
12:18right so take it so be easy on on me
12:22here and I chose and I I chose this one
12:24I know um I my consistency score is is
12:29getting I'm getting an F for consistency
12:31in this one because I'm I'm talking
12:33about a call calendar in this image and
12:36we've been presenting on on put
12:38calendars before but uh I chose the call
12:41calendar to hopefully avoid any
12:44confusion about um negative Deltas here
12:47and I think once you see what I'm gonna
12:49what I'm just gonna uh point out as time
12:52goes on is that this same uh like
12:55visualization makes sense for a put
12:57calendar as well um and really what this
13:00is is just an expression you you'll
13:02recall from our last slide
13:05um let me yeah okay in this last slide
13:10you saw how like over over time this
13:13calendar like becomes closer and closer
13:15to a like a tent right and as you're as
13:18you're approaching that strike and as
13:20time is going by the p&l right the
13:22profit associated with this structure is
13:24getting is getting bigger and bigger and
13:28there's a reason for that and it's this
13:31uh what I'm describing as uh Delta
13:34convexity okay so in this example here
13:39right our uh I think I have this set I
13:42think the uh the calendar like the in
13:45this structure it's a like a a 5825 SPX
13:50call calendar which is out of the out of
13:53the money by like I don't know like 2%
13:55something something like that um above
13:57spot price okay
14:00and the way I had it set up is um you're
14:03like you're selling this upcoming Friday
14:05and you're you're buying the Monday um
14:08after this you know a after that right
14:10so like the only thing in between these
14:12two is the is the
14:14weekend and uh the way that these
14:16numbers here work right from left to
14:19right is is um like the number of days
14:21until this front contract expires okay
14:25when you initially put the trade on like
14:27on Tuesday when I started building this
14:30when I put when I put this together on
14:31Tuesday there were like 4 days until
14:34that front contract expired and then at
14:36300 that's like three days left right I
14:39I did this as it's like a percentage of
14:41day remaining until the front option
14:44expires okay so finally to the point
14:47that I want to illustrate here so if you
14:51if you put this trade on on Tuesday and
14:55then on on Wednesday we get a real
14:59like we get a real ripper in the in the
15:02S&P 500 and the S&P 500 like rallies up
15:072% um that's like that's that's still
15:11great for this trade this this call
15:13calendar is going to um is going to
15:16appreciate uh in price pretty
15:18significantly and you'll do you'll do
15:20pretty well right you'll you'll make
15:22you'll make money on this uh on this
15:24trade and the reason you'll make money
15:25is because your Deltas are increasing
15:27right so if we
15:29uh you know if if it's um it is yeah
15:33okay here here's my like three days
15:35right it goes over time uh and so over
15:38the day on Wednesday your Delta is
15:41increasing from let's say
15:440.25 to
15:46point
15:49uh yeah here okay is it's increasing to
15:53like 0 4 you know at the at the maximum
15:56Point here it's 044 uh one right it
15:59starts to again this is this like time
16:02effect that's that's taking place here
16:04but you can see that the Delta increases
16:06by Point uh 02 Deltas okay so we go from
16:11like 025 to
16:140.46 at the very highest and that's
16:18that's if we get this excellent price
16:20appreciation on Wednesday because we
16:23bought it on Tuesday well what happens
16:26if instead we actually get that price
16:30appreciation on
16:34Thursday okay well on
16:36Thursday our our Delta starts at
16:39approximately the same approximately the
16:42same uh Delta here it's like a tiny it's
16:45like a tiny bit higher because that
16:47front contract has um collapsed in price
16:51more than the uh back contract has so
16:54the Delta is going to be just the back
16:56contract has kept a tiny bit more
16:59long Delta um then then and the the
17:02front contract has collapsed a fair
17:04amount or or has collapsed more because
17:07it's expiring sooner so here we start
17:09from like 0
17:1127 and if we get that same move up
17:15towards
17:175800 oh wow what a difference right now
17:20it's at 08
17:22Delta and so what I'm trying to convey
17:26here is that
17:29this this price increase like this 100
17:32Point SPX price increase uh changes the
17:36Delta on a call calendar on Thursday by
17:39like I don't know what is that like
17:41three like 3x something like that um
17:45whereas on uh Tuesday it kind of only
17:49doubled it right it only it only went up
17:51by 2x
17:54so if you if you like get even closer to
17:57the wire right if you're if you're
17:58riding even closer and you're letting it
18:00go and it's on it's on Friday and that
18:02font front contract is expiring today
18:04and you get you get a nice rip up
18:07towards your 58 you know 5825 point up
18:11here now now we're really talking right
18:14this thing goes from 0.015 Delta to 0.19
18:20so at that point that's more than 10x
18:22right that's like 15 or 14 that's like a
18:2514x increase in in deltas and the price
18:32appreciation of this structure is going
18:34to be commiserate with its move in
18:36Deltas right we I said that back in my
18:39back in my Mr nerd slide here uh right
18:45Delta is like that there's like an
18:48inextricable connection between Delta
18:50and premium associated with the the like
18:53the net position of your contract right
18:56so when price moves in your direction as
19:01this front contract is getting closer
19:03and closer to
19:04expiration smaller smaller moves in the
19:08underlying Equity generate a larger
19:13increase in the value of your overall
19:17position and what I think is like is
19:21really is is really kind of magical
19:24about that is that from a psychological
19:28perspective it kind of makes these
19:29easier to hold on to right
19:34because if price is steadily moving in
19:37your direction if you just hold an
19:40outright if you just hold an an outright
19:43out of the money call and you just like
19:45wait and the underlying price reaches
19:47your strike by
19:50expiration like you had you made a good
19:52prediction but you didn't make any money
19:54you lost money right because like you
19:57you know you had to pay for that call
19:58and price didn't get high enough right
20:00it's like over time you're constantly
20:02chasing like the like the value of the
20:05call you're watching it psychologically
20:08and you were right in your prediction
20:10but you're watching the value of your
20:12call the premium on that call like not
20:14go up when you were right and H the
20:17frustration right like I can't I you
20:21don't have to you don't have to tell me
20:23about that kind of that kind of
20:25frustration right it's aggravating to
20:27make a great forecast
20:29and then to have the trade actually lose
20:33money because your forecast was was good
20:37but price didn't go up enough or it
20:39didn't move up fast enough well call
20:43calendars that are out of the money if
20:44you're predicting a price increase they
20:47do away with this problem they're like
20:49the opposite of that if price steadily
20:53moves in your direction if you forecast
20:55a price increase and and that and that
20:58like just perfectly Graces its way up
21:00into that area it's like the opposite of
21:03that effect uh where you're just holding
21:06an outright call and you're watching it
21:08not appreciate um and you're you know
21:11cursing the market gods for for giving
21:14you this forecasting gift and a position
21:18that's not making any money right the
21:20calendar Trader is looking at his or her
21:24p&l and thinking nice right like this
21:27the value of this is going up um
21:30commiserate with my forecasting skill so
21:36uh to wrap up my Delta section here with
21:39a with a little
21:40bow what makes calendars unique and and
21:46appealing is that your uh your price
21:52prediction will pay off really well if
21:57if the underlying kind of like cruises
22:00into like cruises into the area where uh
22:04you're forecasting price to be and and
22:07you could see right it's it's uh that is
22:10demonstrably accurate because the the
22:13Delta on the like the net call calendar
22:18here um becomes quite large as that
22:21front contract is expiring compared to
22:25when the trade starts like if SPX price
22:27just teleported up to 5825 it I mean
22:30it'd be great your your Delta would
22:33increase right you would make you would
22:35make some money on this trade but you if
22:37price just teleports up you want to own
22:40you just want to own a call or you just
22:42or if it teleports down you just want to
22:44own a put because you're going to get
22:47all the the positive effects uh that are
22:49built into that in that scenario but if
22:53price just kind of Glides in One
22:55Direction you know if it kind of just
22:57chops up and down you chops up and down
22:59into this range um then your payoff is
23:02going to
23:03be uh is is going to be really really
23:07good and and again like I I will lean on
23:10this from a theoretical angle by saying
23:13look at the growth of the
23:16Delta the the Delta change from like
23:19trade initiation at being you know Point
23:2302023 relatively low to being 10 times
23:26higher than that at expiration
23:29um of the front contract where you're
23:31predicting price is going to go uh
23:34that's the that's the conclusion of my
23:36my Delta uh section if there obviously
23:39if there are any questions uh I'm happy
23:42to I'm happy to field them and uh I am
23:45also working on a way to make this kind
23:48of visualization um available because I
23:52do think it helps kind of build up your
23:54intuition um about how about how an
23:58option structure payoff is g to um is
24:01going to work over over time so um you
24:05know stay stay tuned hopefully we have
24:07something to we'll have something that
24:09that helps um Express uh or that helps
24:12you see how this trade is
24:16gonna manifest on your p&l over over
24:19time what effect if any at all does
24:23gamma have on these put calendar spreads
24:27so the gamma is is actually what's like
24:30accelerating these Deltas higher and
24:32higher as um as we March closer to the
24:37expiration of the front um
24:41contract so your net like your net gamma
24:46on this on a a put or a call calendar
24:50that's out of the money in this way is
24:53is going to be positive and it's going
24:56to move Deltas in your it's going to
24:58like it's going to move the net right
25:01the combined long and short Deltas of
25:04the position in in your favor um faster
25:09and faster as we approach um
25:13expiration like you're still going to be
25:15net positive gamma over here uh around
25:18like you know day Zero and day one of
25:20your trade initiation um and you can see
25:24like there like the Leaps and Bounds so
25:27to speak right the delta increases
25:29they're not really that fast as you as
25:31price moves up right from from this like
25:34$10 SPX change um gives you an increase
25:38of
25:3903 Deltas uh which means like the gamma
25:43there is like is relatively small and it
25:46even starts to slow down here as you get
25:49closer to the like the long short strike
25:53whereas when you get over here closer to
25:56expiration okay well now
25:59a a $10 change from uh 5730 to 5740
26:04changes the the net Delta of the
26:06position by
26:090.15 uh which I know doesn't seem like a
26:11ton you know like we're we're talking
26:14about these tiny fractions and
26:15everything but got to remember SPX is a
26:18$5,700 product right so like one Delta
26:23it's like valuable is a valuable thing
26:26to have on an SPX um on an SPX contract
26:32right you cherish you cherish every
26:34Delta you get um on when you're tra when
26:39you're TR trading the SPX because it's
26:41such a large U it's such a large product
26:43right so like you know take a step back
26:46and remember oh hey I'm trading a $5,700
26:50stock uh so when it moves two Deltas
26:54that's like that's pretty
26:56good so why KK asks is it best to
27:01exercise the long position when it comes
27:04in the money and what is the best
27:07situation to exit the strategy okay yeah
27:10excellent excellent questions okay
27:14so in this in this particular example um
27:18with the SPX I uh like the SPX is a cash
27:23subtle product and it's also a European
27:25style option um so you never have to
27:27worry about early assignment or anything
27:29like that because it can't be assignment
27:32doesn't happen until expiration right
27:35it's only only allowed at expiration so
27:37SPX is um kind of a special case
27:41here the inter if you were uh if you're
27:44dealing with like a single single name
27:45Equity or spy QQQ something like that
27:49generally generally speaking you would
27:53want to uh you would want to exit at
27:56your strike price right that's ideal
27:58place to exit but I say I say that um
28:02and gosh I just I hate to invite
28:04discretion into this sort of thing but I
28:07would say you wanna like you want to use
28:10your you want to use your forecast as a
28:12guide because with a calendar spread if
28:17the underlying price just like rips
28:20right past your right past your strike
28:23um there like there's a time where
28:26you're actually going to where where you
28:28you'll wind up with kind of a with a
28:30loser right which can be um annoying uh
28:35that you know price that price moved uh
28:38that price moved too much but like you
28:41can use your use your forecast as a
28:44guide right I I like am almost cringing
28:47at hearing myself saying this but like
28:50you it's like a it's kind of a it's kind
28:51of a discretionary God it's kind of a
28:54discretionary decision I would argue
28:57that in an Ideal World you want to
29:01always be able to trade at least two
29:04right like two units of calendars so you
29:06technically have four contracts two
29:08spreads and you could initiate you would
29:11initiate the trade and get your fill and
29:13like the first thing you could do is set
29:14a limit cell at maybe um like
29:21150% uh profit right like uh like the
29:25value of the spread has increased by say
29:27150%
29:28because that's not that's not un
29:31unreasonable or unachievable if price
29:34begins to move in your direction
29:36relatively um relatively quickly as far
29:41as as far as exercising um exercising
29:45the long that's a that's an excellent
29:47question because in theory if you were
29:49trading this on uh I I know some one of
29:54these uh one of these China names that
29:55just went ballistic PDD okay if you had
29:59a calendar on PDD at 110 and it rallied
30:04up to 150 well now you're shorter you're
30:07shorter call that's $40 in the money
30:09right and you have um uh you have
30:12assignment risk there right you're at
30:15risk of needing to uh or rather delivery
30:17risk I guess technically you're at risk
30:19of needing to deliver a 100 shares of
30:22PDD um and uh you know the market price
30:25of those is 150 and you promis to to
30:28deliver at 110 and that could be a that
30:31could be an unpleasant loss right there
30:33what I what I suspect would happen or or
30:35at least you know what I hope would
30:37happen is that if you happen to be away
30:41from your screens uh and you have a
30:44calendar on and you have one of these
30:45like PDD situations where the underlying
30:48price goes way past your your strikes um
30:52my my hope would be that your broker has
30:55the has the understanding uh probably
30:58after communicating you with about about
31:00this uh that you don't want to deliv you
31:03don't want to be forced to deliver those
31:04shares and so what would happen is that
31:07um should an early assignment come your
31:10way and you are obliged to deliver 100
31:12shares of PDD um you would uh your your
31:16broker would exercise your would
31:19exercise the long call to give you those
31:21100 shares um and and have you uh
31:25deliver you know deliver that way right
31:27so you don't don't have to so the next
31:30so the next day you don't wind up short
31:32100 shares of PDD and um dealing with
31:34the margin implications of that so I
31:37would say uh on a case where your
31:40strikes just get blown away and uh the
31:44underlying rallies far far beyond uh
31:48where you you had forecasted the price
31:50to move youd want to have your broker um
31:53exercise the long leg uh to cover your
31:56obligation to deliver shares on the
31:58short leg

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