One of the most important factors when trading debit spread strategies is the share price and strike prices, and what is available. A common mistake some option traders make when using debit spreads is not paying enough attention to these and how they can seriously impact the chance of profitability. To explain this, I’ll take a look at 3 different debit spread strategies in a Three Part series: The Neutral Calendar Spread, The Reverse Iron Condor, and the Strangle strategy. First up is the Neutral Calendar Spread….
The Neutral Calendar Spread: is a strategy that has 2 “legs”. There is a sell side and a buy side. I prefer to use this strategy with stocks/ETF’s that have weekly options, when available. The weekly option is the sell side. The monthly (or whichever you choose that is a further out expiration that the weekly) is the buy side. This is a strategy that takes advantage of time-decay and a lack of a large price movement. Let’s assume the security I want to trade has a share price at $50.00 at the time of trade placement. This is an ideal share price because there will be $50.00 strike price increments. So, if I was trading XYZ stock using a Neutral Calendar Spread, the trade would look like this:
Sell 10 December 2015 XYZ Calls
Buy 10 January 2016 XYZ Calls
But what if the share price is at $51.50, and I look at the options chain and realize that there are only $2.50 strike price increments? This is an problem, because the trade is no longer neutral and it puts you at an immediate disadvantage from the start.
Today, on my Trading Forum, we had 2 earnings-based Neutral Calendar Spread based-trades. There would have been 3, but this example will explain very well why I did not place it: The stock in question is General Mills (GIS), which reports earnings before the bell tomorrow morning: At the time of looking at the trade, the share price on (GIS) was at $58.80/share.
Sell -25 GIS Dec15 57.5 Call
Buy 25 GIS Jan16 57.5 Call
I only had two choices as far as strike prices, to use either the $57.50 calls, or the $60.00 calls:
Knowing the share price, and the strike prices available, this would cause a major problem of neutrality regarding the trade itself, as this shows:
As you can see from the Profit/Loss chart, the break-even points are uneven, clearly favoring the downside movement more than the upward movement by more than $2.00. That may not seem like a big deal, but it is. This can be the difference between profitability and a loss. The great thing about the Neutral calendar Spread strategy is that it does allow a good amount of price movement, just not excessive. My concern on the (GIS) trade would be if the stock moved up too much. I would be much less concerned about the downside movement. However, when you see a trade have a set-up like this (GIS) example, avoid it like I did today, even though it may initially seem like a good trade.
Overall today, 3 earnings trades, should have 2 tomorrow. (RHT) especially should be a good one.
If you have any questions about this strategy or specific stocks, you can e-mail me at email@example.com or post a comment. I usually respond very quickly. Coming up next is the Reverse Iron Condor…