Protecting a Short Credit Spread Position
The calendar serves as temporary but limited risk reduction.
Minyan Steve writes:
In reference to Kite protection, if you were short eight of the Jan RUT 520/530 put spreads, would a 550 Feb-Jan put calender serve as temporary protection in case of a further RUT fall toward, but no further than 550?
(Editor's Note: Later, it was learned that Steve meant the 510/520P spread, but the conversation isn't affected.)
I've tried generating risk graphs of OTM put calendars with OTM put spreads, but am not sure if they're accurate in their risk assessment.
1. Yes. The calendar serves as temporary, but limited protection.
Consider this: If RUT moves to 550 "and no further" you won't need much, if any, protection. The usual reason for buying insurance is to make the original position less risky. When short the 520/530 put spread, RUT moving towards 530 represents the big problem.
The insurance purchased should do something that reduces the risk of owning the original trade -- in the event that the potential trouble does occur. And that would be making your position better as RUT approaches 530. The concept of buying insurance is to generate profits that partially offset losses resulting from the original trade.
Below is the risk graph for owning two-lots of the RUT Feb/Jan 550P spread, with 46 days remaining before expiration:
Here's the same position three weeks later:
You can see a profit at the 550 level, as anticipated when the calendar moves to the strike price. But, where protection is needed (530), you get no help.
2. The problem with calendars is that they're profitable over a limited price range. If the underlying moves much lower than the strike, the effectiveness of owning the calendar disappears. If RUT were to move quickly through the strike (550) and head to your big problem area -- near 530 -- there are two big factors that become important:
a) The calendar has already moved past its most profitable price -- and that's near 550. Thus, as RUT moves lower, the calendar becomes worth less and less.
b) The calendar may possibly continue to maintain its value. If IV increases sufficiently (spread is + vega) it may offset the continued price decline (the spread is + delta as RUT moves through 550).
For the calendar to provide the protection you seek, you'd be advised to exit, with a profit, as RUT reaches 550 (or perhaps a little lower). There's no point in holding "protection" that's done what it can do, and is no longer protecting.
Bottom line: The calendar is okay as a stand-alone trade, if you want to make that play. But it doesn't offer quality protection. "Quality" means it provides protection. Period, with no chance that protection disappears on a continued price decline, or the passage of time.
Note: To protect the RUT Jan 510/520P credit spread, the Feb/Jan 550 P spread is even less effective than it is in protecting the 520/530P spread.
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