Alright ladies and gents. Time for an educational strategy walk through. In light of the volatility swoon mentioned in my last post, attractive credit trades have been hard to come by. And that’s a bummer for traders who were looking to fade the overbought market with bear call spreads. The lack of premium is making the already lopsided risk-reward even worse. That is, option sellers are taking lots of risk for just a wee bit of profit.

What to do, what to do?

Harness the power of calendar spreads. A put calendar should do the trick. It’s a debit trade and thus capitalizes on the sale going on in options land. Plus we can position it to profit if the much needed pullback in this overheated market finally materializes.

The gist of the put calendar (aka the put horizontal spread) is to buy a 2 month option while selling a 1 month option (or thereabouts) of the same strike price. The strike selected serves as your target, the price level you hope the stock reaches in the near future. And since we’re thinking the market could drop a bit we’re going to use OTM puts to set this puppy up.

The position starts out delta negative which allows you to rack up profits during the downturn. It’s also positive theta providing profits as time passes. Finally, it’s a long volatility play. A rise in implied volatility aids the trade which is appropriate for the current market given the low volatility levels greeting investors this week.

I’m using Wednesday’s closing prices to illustrate this. In deciding which strike price to use let’s assume we think SPY might retrace to $198 sometime over the next month. To structure the trade simply buy to open the May 198 put while selling to open the April 198 put. Let’s say we buy the May 198 put for $2.98 while selling the April put for $1.13 for a net debit of $1.85.

The max loss is limited to the initial $1.85 debit. The lower the volatility the cheaper the options. The cheaper the options the lower the cost of the trade. And, finally, the lower the cost of the trade the less risk involved. That’s why put horizontals become mighty attractive in a low VIX environment.

Check out the risk graph of the position below.

To more accurately estimate the potential profit if SPY ends up dropping to our target ($198) we can move the date forward a few weeks into the future. Let’s assume SPY falls to $198 on April 1^st. Per the risk graph the price drop coupled with the time decay will deliver a $53 gain, or roughly a 30% return on investment. And that’s not accounting for any type of implied volatility increase that may kick-in along the way. If we get a decent volatility ramp the profit will be even higher.

And if more time passes and SPY is sitting at $198 on April 5^th or April 10^th, or whatever, your profit will be higher as well.

So there you have it folks. An interesting alternative to bear call spreads when volatility is low and a price drop is expected.

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