Lawrence G. McMillan reviews Anyway's trades.

This All-Star Commentary post features four trades (long call 1, short call 1, long call 2, short call 2) from Anyway. Thanks for logging your trades for the TradeKing Community, Anyway!

"Sold the March 30 calls, bought the Jan 09 30 calls, debt of 4.70. Seems like owning a Jan 30 call for cheaper than just outright buying the call  (the time value for 8 days was only 4.70 less than the time value for 300 some days)" - Anyway calendar spread entry

Anyway,

Thanks for explaining your ideas surrounding your BSC March Jan 2009 30 Calendar Spread. I see that after you entered the first spread, you put on a second call calendar spread at the 25 strike. The combination of these trades may be referred to as a double calendar or dual calendar. The characteristics of dual calendar spreads are similar to textbook ones. Let's go to the Rookie's Corner before we begin.

ROOKIE'S CORNER

BSC = 34.88 as of 3:13 on 3/14/08

3/14   Trade 1: Bought to open     1 BSC Jan ‘09 25 call @ 13.61        12:02 pm

3/14   Trade 2: Sold to open          1 BSC March 25 call @ 8.91            12:02 pm

Spread trade: Bought 1 BSC March-Jan ‘09 25 Calendar Spread @ 4.70

3/14   Trade 3: Bought to open     1 BSC Jan ‘09 30 call @ 17.57        1:38 pm

3/14   Trade 4: Sold to open          1 BSC March 30 call @ 13.61         1:38 pm

Spread trade: Bought 1 BSC March-Jan ‘09 30 Calendar Spread @ 3.96

Long Calendar Spread with Calls - Play #27 (Education > The Options Playbook > The Plays > Play #27)

When running a calendar spread with calls, you're selling and buying a call with the same Strike Price, but the call you buy will have a later expiration date than the call you sell. You're taking advantage of accelerating time decay on the front-month (shorter-term) call as expiration approaches. Just before front-month expiration, you want to buy back the shorter-term call for next to nothing. At the same time, you will sell the back-month call to close your position. Ideally, the back-month call will still have significant time value.
 
If you're anticipating minimal movement on the stock, construct your calendar spread with at-the-money calls. If you're mildly bullish, use slightly out-of-the-money calls. This can give you a lower up-front cost.
 
Because the front-month and back-month options both have the same strike price, you cannot capture any intrinsic value on the options. You can only capture time value. However, as the calls get deep in-the-money or far out-of-the-money, time value will begin to disappear. Time premium is maximized with at-the-money options, so you need the stock price to stay as close to Strike A as possible. 

BREAK-EVEN AT EXPIRATION

It is possible to approximate break-even points, but there are too many variables to give an exact formula.
 
Because there are two expiration dates for the options in a calendar spread, a pricing model must be used to "guesstimate" what the value of the back-month call will be when the front-month call expires. TradeKing's Profit + Loss Calculator can help you in this regard. But keep in mind, the Profit + Loss Calculator assumes that all other variables, such as implied volatility, interest rates, etc., remain constant over the life of the trade - and they may not behave that way in reality.

THE SWEET SPOT - the floor for the stock price

You want the stock price to be at Strike A when the front-month option expires.

MAXIMUM POTENTIAL PROFIT

Potential profit is limited to the premium received for the back-month call minus the cost to buy back the front-month call, minus the net debit paid to establish the position.

MAXIMUM POTENTIAL LOSS

Limited to the net debit paid to establish the trade (if the entire position is closed prior to front-month expiration).

MARGIN REQUIREMENT

After the trade is paid for, no additional margin is required if the position is closed at expiration of the front-month option.

AS TIME GOES BY

For this play, time decay is your friend. Because time decay accelerates close to expiration, the front-month call will lose value faster than the back-month call.

IMPLIED VOLATILITY

For this play, although you don't want the stock to move much, you're better off if implied volatility increases close to front-month expiration. That will cause the back-month call price to increase, while having little effect on the price of the front-month option. (Near expiration, there is hardly any time value for implied volatility to mess with.)

TRADE DISCUSSION and RESEARCH

This is an extremely interesting, but also surprisingly complicated, position.  First, let's address the premise for establishing this calendar: "Seems like owning a Jan ... call for cheaper than just outright buying the call  (the time value for 8 days was only 4.70 less than the time value for 300 some days)".  That's true, as far as it goes, but it's a common novice mistake, for it ignores some important factors. 

Yes, if the long options hold their current level of implied volatility, then the time decay will work rapidly in your favor, and will have a huge profit on this trade.  However, whenever you see this sort of a situation - that is, the short options are selling for nearly the price of the long options - then there is usually huge volatility risk, and that is the case here.

Having said that, let's see where and why this position might profit or lose.  First of all, calendar spreads have the following traits - and this one has them in spades:

Short gamma - in other words, you generally don't want the stock to move far from the strike

Short theta - time decay works heavily in your favor

Long vega - if implied volatility drops sharply, you will often lose money in a calendar

First, let's just address the 25 strike calendar, and then we'll add in the other one.  The following graphs are drawn with the software called Expected Return Calculator (© 2007, McMillan Analysis Corp.).  It can be purchased as stand-alone software to run on a PC.

All calendar spreads (in fact, any position), should be evaluated on the expiration date of the shortest-term option in the spread.  In this case, then, we are interested in analyzing these calendars on the March expiration date - next Thursday, March 20^th (Friday is a market holiday).

First, let's assume the best case - that implied volatility levels hold up for the next week.  The profits look tremendous in that case (Figure 1):

The profit range is roughly from 15 to 70, and if the stock is near 25, large profits in excess of 100% can be gained.  In fact, statistically, the expected profit is $337 - 72% of the $470 investment.  For these reasons, this looks like a tremendous position.

For the record, you paid an implied volatility (or implied) of about 124% for the LEAPS calls, while getting nearly a 500% implied for the option you sold.  This is why the spread looks so good - you have established the spread with a huge horizontal skew in your favor.  That is, the long option has a much lower implied volatility than the option you sold (NOTE: the implied volatility on Bear Stearns options yesterday, March 14^th, are arguably the highest I've ever seen on an individual stock - and I've been trading options since the beginning, in 1973).

Click here for a larger image. (Figure 1)

But now let's take a more realistic look at this position.  Do you really think that a) the options are this expensive if the marketplace assigns much chance at all of the stock being relatively unchanged over the next week, and b) that these implied volatilities - the highest ever - will hold up for the next week?  I don't think either one is true.  So your gamma risk (risk of price explosion by the underlying) and your vega risk (risk of a large drop in volatility) are large.

Let's assume that the implied volatility of the LEAPS option in the spread (Jan '09 25 call) drops to 80% by next Thursday's expiration.  Furthermore, we'll assume that the implied vol of the March 25 calls drops to equal that of the long LEAPS options, so you capture the skew completely.  Even so, your profit graph now becomes that as shown in Figure 2.  Of course, no one knows where the implied volatility will be in a week, but just note that a week ago, at-the-money LEAPS calls traded with an implied volatility of only 47%.

Note that a profit can still be made, but now it's much less likely.  The profit range has narrowed to roughly between 20 and 36.  Do you think BSC will be between those prices next Thursday?  Also, the reason that I chose 80% as the implied vol for this evaluation of the position was that it is at this volatility that the expected profit essentially falls to zero (actually, it's -$1.31) as you see from Figure 2).  So, this is sort of your "breakeven implied volatility."  If vol is above 80, you have a positive expected return, but if it falls below 80, this position is expected to lose money. 

Click here for a larger image. (Figure 2)

This also does not take into consideration what might happen if BSC were forced into a merger situation with, say, J. P. Morgan (JPM) this week.  If it's a cash deal, the implied vol of all options would drop to zero and all time value would disappear, except for what remains in terms of risk arbitrage - which would not be much.  If it's a stock deal, the options would drop in implied vol to reflect that of JPM - currently about 46% (although normally lower than that).  At a 46% implied, this position would not have a profit at any stock price - the loss on the LEAPS calls would be greater than the gain on the March calls at all stock prices!

In summary, these types of calendar spreads always seem attractive, but that is because you mentally figure the long options in the spread will hold their value (i.e., their implied volatility will remain high).  That is usually faulty reasoning, and if the calendar spread cannot handle a drop in implied vol of those longer-term options to a more reasonable level, then it's probably not a good position.

Dual Calendar

Here's how the dual calendar spread position looks - both at full volatility (Figure 3) and at reduced (80%) implied volatility (Figure 4).

Click here for a larger image (Figure 3).

Click here for a larger image (Figure 4).

Normally the profit graph of a dual calendar has more distinct "humps" at the strikes, but since they are so close together here, it's more of a trapezoidal shape.  You can see that the dual calendar helps things out a little bit, by looking at Figure 4.  At an 80% implied vol, there is still an expected profit of $140, and the profit range is roughly 21 to 45.  That's helpful.  In fact, the "breakeven volatility" for the dual calendar is about 71% -- still quite high, but lower than the 25 strike calendar by itself. 

Summary

In summary, your thought process was good in that you recognized the potential advantage of selling a very expensive option against one with much lower implied volatility.  However, the vega risk is so great here.  You might make money in this position if you hold it until expiration, but it's unlikely.  You would probably be better off to hope that implieds hold up for a couple of days and that the time value decay over that time allows the spreads to widen enough to take them off for a profit at that time.  Of course, any takeover of BSC will be harmful to these positions, unless the deal price is in the 25-30 area (which is possible, I suppose).  It will be interesting to see what happens here.

This comment and any market data included here were prepared on 3/15/08.

--Lawrence G. McMillan

President

McMillan Analysis Corporation

All-Star Commentator

To learn more about these trades, click here to read the follow-up discussion.

For a list of previous All-Star Trades, please click here.

Options involve risk and are not suitable for all investors.

Please read Characteristics and Risks of Standardized Options.

While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.

The Greeks (Delta, Gamma, Theta, Vega, and Rho) represent the consensus of the marketplace as to how the option will react to changes in certain variables associated with the pricing of an option contract. There is no guarantee that this forecast will be correct.

Lawrence G. McMillan has a professional business relationship with TradeKing.

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