16/mar/2011: The situation in Japan gets bleaker by the minute. There’s even talk of an uncontrolled chain reaction (a.k.a a full nuclear explosion) brewing in the Fukushima plant.
This made most of the indices today to take a dive, and this got me thinking. I’m still convinced that my MAY/JUN SPY calendar is a valid trade, but in the short term there seems to be enough bad news (and fear mongering) so that this market will retreat for a while, then maybe, resume it’s upward trend.
The general idea is that there is an opportunity to profit from the short-term decline in price (with defined risk, of course) and then when the dust settles, and the third major economy in the world get’s it act together, things will look peachy once again and the buzz will shoot the price to where my calendar is most profitable or somewhere close.
So I entered a hedge trade: STC SPY APR -10 124C BTC SPY APR +10 126C @ $1.28. That’s a bear spread
Profit & Loss
The most I can lose in this trade is $2,000. That’s the difference between the strikes times the contract size (126-124 = 2 x 10 x100 = 2k). I sold the furthest OTM call, and bought the closest ITM call, which resulted in a credit. I received $1280 for entering this trade, so the total risk is greatly reduced to only $720
The possible profit for this trade is defined. The most I can make is $1280, which I already received. This will happen if this market ends up below $124 by April expiration (Saturday, Apr 16th.)
Entry & Exit
The entry was timed to coincide with the end of this trading day — that’s what STC means: Sell To Close –. This happened half by chance and half because at this time the call price was quite increased. I could have place this trade on more strike up to be more delta-neutral (at $1.20), but the price on this one was higher ($1.28), so the profit was better (6% better, in fact).
Of course I could have sold the 65/67 april bear spread for $1.99 (that’s the furthest down trade I could place in this market at this moment) But I really don’t think that this market will fall that hard in one month. I could always be mistaken of course, but if it does bottom out like that, then I still keep my $1280 as opposed to the $1990 on the 65/67. The difference, in my opinion is not worth going for a totally unrealistic trade that will make me lose my $10 almost for sure.
The other thing that made me time this entry is that this market is very liquid, and the bid/ask spread for each call was 3-4 cents. Right after the market closed, the spreads shot to 40 cents. The volume on these calls since they’re close to being ATM was quite high and this meant that I could get a fill and actually enter this trade at my price or very close. There’s no point in fantasizing on a trade when you can never enter it, is it?
About timing the exit, here’s the combined P/L graph to lay out the strategy:
If this is the big one and the market bottoms out: I’ll make money ($1170). If the market rallies like there is no tomorrow, I’ll lose $830. Let’s review each possible outcome to see what would be needed to protect this trade:
Massive sellof: The market has totally gone against my original trade; luckily I’m hedged and I should close all my current SPY positions prior to april expiration. I’ll make money in the process. That’s what hedges are for.
Massive rally: The market has gone totally batshit insane and in the process, has ruined my original trade, on a way that I have not hedged for. Panic close all my positions, take my loss and lick my wounds. The possible loss of both trades is added up, so my measly $110 possible loss on the calendar has balloned up to $830 because of the hedge strategy. If the price hikes up to $138 or so, bail and take a $100-$200 loss.
Price just hangs here: This is a tricky one. This means that the hedge is useless, and I should close it before any more damage is done but keep the calendar open. If left open till the first week of April, The model says that this spread will lose about $100, that’s my cue to close it and move on.
In summary: Price goes down hard, close anytime before Saturday, April 16th. The decision should be made in the first week of April, at the latest.
Early assignment.
What should I do If I am assigned early? Let’s see what I’m sitting on:
I ACQUIRED THE OBLIGATION TO PROVIDE 1k SPY SHARES @$124 to some poor chap. Simultaneously I ACQUIRED THE RIGHT TO BUY 1k SPY SHARES @$126 from some other poor chap.
The only risk I have is that the first poor chap decides that he wants to actually own 1k shares of SPY, and he will be paying exactly $124 for each one. When can this happen? It can happen anytime on this market, but it only makes sense IF the price of SPY passes the $124 mark. Why is this? because he could buy at $124 and sell it to whatever higher price is at that moment.
My possible loss would increase continuously until passing the $126 mark. At that moment, I can exercise my own right to buy SPY stock at $126 and provide this guy with the underlying I’m supposed to. The difference is $2, hence my max loss. I’m supposed to know what to do in this unfortunate event, but I don’t have a clue (yet).
21/mar/2011: Ah, the Spring is here! and perhaps anti-climatically this trade started losing serious money, really fast. Over the weekend there where no further new bad news, other that a NATO strike to Libyan military objectives to enforce a no-fly-zone on that country. The nuclear threat in Japan is not growing but stable, and all this made the market rally for the last few days negating my original hedge idea.
I need to time this better. When I placed this trade, the downward movement had ended. This is important!, Could it be possible that when I feel fear, is just when the retail traders like me also feel fear?, maybe we (Me and the other retail traders like me) have access to the same information, and react at the same time in the same direction, we buy or sell at the same time.
This would mean that above us, the market makers and heavy hands soak (or stoke up) the selling or buying wave of the weaker hands, and then go profit from it, usually in the opposite direction. I need to place more losing trades to get a feeling as where is that point. Maybe the strong hands react much more quicker, setting up the trap for us weak hands.
So: I just placed a closing trade for this bear spread: SELL -10 SPY 126C, BUY +10 SPY 124C @$1.64. This is implying a loss of close to $400. Which is a bit more that half the maximum loss of this trade. I’m SURE that the minute I get filled on this order the market will turn around and laugh at me.
The other thing that might happen is that I never get filled, and the losses keep mounting. 
On that case, the loss will shoot up to the projected $720.
I got filled a couple of hours later @$1.64. Total loss for this trade: $1280 initial credit- $1640 closing debit – $60 total commissions= ($390)
END-OF-TRADE