Doc Maher analyzes Pacman's spread in Visa.
Pacman,
In my opinion, calendar spreads are about the most complicated option strategies there are. However, they are among my most favorites. To begin, let's review the basics of a calendar spread. Basically we want to capture the premium of a short term option. To do this we have to short the option (sell to open) and allow time decay to reduce the value. Potentially, if the option we sold expires worthless, we will have captured the entire premium.
This is a similar goal when we use the covered call strategy. This strategy involves stock and options. We own the stock and sell a call option with the hopes that the call we sold will become worthless. If the call we sold expires ITM (in-the-money) our stock will get called away. The good news here is we already have the stock, so getting called out is no big deal.
Let's go back to the calendar spread now. This is similar in that we sell a short-term option. However instead of owning stock to "cover" the position, we buy another longer-term option. The simplest case is when the two options used are the same strike, but in different months. We'll stick with this for now.
So how does this work? Well let's look at your trade. You sold the Visa May 80 call for $3.15. If Visa finishes under $80 at May expiration, this call will expire worthless. You made the trade on April 28; Visa was trading at $76.92.
But what happens if Visa ends up over $80? Then you may get called out of Visa shares at $80 as a result of an early assignment on the short call. (Note: early assignment of a short option position may happen at any time for any reason.) But wait - you don't have any shares of Visa to sell. So what happens? Well the shares would be automatically shorted in your account as a result of the assignment. In order to cover this new short stock position, and therefore close it out, you would have to buy back the shares at whatever the going rate would be, even though you sold the shares at $80. If Visa goes up to $100, you can see where this could be a problem resulting in a loss of $20 per share. The premium you got for selling the May call when you entered the trade won't make up for this loss. Theoretically your loss is potentially unlimited as the stock goes higher and higher. We are leaving out an important detail here - the September 80 call.
So to avoid this problem and "cover" your short May 80 call, you bought the Visa September 80 call for $7.75. Why does this "cover" the short May call? Because if you get called out on the short option, you have the long call to back it up. So if you are assigned on the short call, and the stock increases, the long call may rise in value as the stock goes higher. Although the trade may end up being a loser, the risk is limited. Unlike a covered call, the calendar spread will lose if Visa goes too high.
Since May expiration has passed, I will use Visa June options in the following examples. In order to recreate the situation when you placed your trades, I will need to use the 85 strike instead of the 80 strike, since the stock is higher than it was before. Look at the P&L for the covered call.
Click here for a larger image.
Here we bought 100 shares of Visa at $82.37 and sold the June 85 call for $3.30. There is a loss in the position if the stock goes down more than $3.30 (the amount we collected). Take note, this will make a profit no matter how high Visa might go.
The P&L of a calendar spread looks a lot different. The following image is for selling a June 85 call and buying a September 85 call.
Click here for a larger image.
The curve shown is on June expiration. We can see that, if Visa goes below $78.66 or above $93.65, the model is predicting a loss. With this strategy we are limited to a profit range. Unlike the covered call, if Visa goes too high we will have a losing position, but the profit range might seem pretty good to us. Here's where things start to get complicated.
A few items to remember:
1. There are three main things that impact option prices: Underlying stock price, Time, and Implied Volatility.
2. Most option strategies try to capitalize on at least one of these and will be affected by all three.
3. Know what makes your strategy work and know how each of these things affects it.
As we mentioned, a calendar strategy is primarily trying to capture time. As time passes, the short June call will decay faster than the long September call. This is because in general options decay faster as they get nearer to their individual expirations. The June option is closer to its expiration than the September option, so it will lose value faster. So if the September call will hold its value and we own it, and the June call will lose its value and we sold it, we are looking to gain the difference in time decay between the two options.
The complication is that calendar spreads are impacted not only by time, but by changes in the stock's price and changes in Implied Volatility. And these factors play a very large role in determining if the strategy will be profitable.
The time issue we understand. We want time to pass and that's what makes this strategy work. The stock movement we understand, we need the stock to stay between $78.66 and $93.65 and the closer it is to $85 the better because that's our maximum profit point.
Now comes the question of Implied Volatility. What happens if the IV drops? This part will be discussed in my next post. Until then, there are some great All-Star blogs on the subject. Nehemiah watches time pass will get the beginner started. Trader Mauled by Bear goes a little deeper and is similar to your trade. Dusting off the Trader's Vault is an in-depth discussion covering volatility skew and more.
Thanks for the trade, Pacman. I'll be posting more on this soon.
"Income Trader"
For a list of previous All-Star Trades, please click here.
Would you like your Trade Note to be chosen? Read more.
This comment and any market data included here were completed on 5/18/08.
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.
Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
Jonathan F. Maher, PhD has a professional business relationship with TradeKing.
