Doc Maher wraps up Pacman's spread.

Pacman,

In my last entry, I noted a few things about options.

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.

Calendar spreads are impacted by all three: stock price, time, and implied volatility. 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 (image below) and the closer it is to $85 the better - that's our maximum profit point.

Click here for a larger image.

That leaves volatility. You noted that "the calendar spread made for a nice wide profit band." I agree, fifteen dollars is a lot. However, you may not realize that if IV drops, that range is going to shrink. The more IV drops, the smaller the range gets.

So what may cause IV to drop? The most common event is the release of earnings.

Let's look at the IV chart:

Click here for a larger image.

Visa had an IV "crush" from 57 to 42 after earnings were released. Let's take another look at the P&L graph.

Click here for a larger image.

In this image, I lowered IV by the same 15 points we observed with the volatility chart. As you can see, the profit zone has been squeezed significantly and the max profit was dramatically reduced. This makes our chances of success in this sample trade a lot less likely.

In going back to your actual 80 strike calendar trade, things might have worked out for you. As of the close on Expiration Friday, I show the closing price of Visa stock at 82.37, the September 80 call at about $10.30, and the May 80 call was in-the-money by $2.37. This means that the total position at expiration was $10.30 - $2.37 = $7.93. Initially the trade cost you $4.60, so it gained $3.33 (7.93 - 4.60). If you did not close out the short May 80 call just before expiration you would also have to deal with getting called out. But that's a subject for another discussion.

The gain of $3.33 is a great return - over 72% ROI. So what happened? Well as you said it's risky. Fortunately Visa moved just past the sweet spot of $80 and that made all the difference. If Visa had not moved towards 80, the loss in IV may have made the total position a loser. This is in spite of the fact that the P&L graph may have showed the position to be profitable when you entered.

Back on May 7 and 8 when Visa was hitting $90 this trade may have been painful. The short May 80 was almost in-the-money by $10. If Visa had stayed up there, this trade would not have made anything. If it had stayed at $77 or gone lower, it would have lost for sure.

When a calendar spread looks really good I'm always suspicious. It's usually because the IV is really high and there is usually a reason for that. So make sure that you know what that reason is. In general, I would not play a calendar spread if I thought that IV might move down. This trade just before earnings is doubly risky. First - we expect the stock to move on earnings, but a calendar spread is only profitable in a range. Big movement is not what we want. Second - the IV is probably going to drop dramatically after earnings and that is also going to work against us.

Bottom line: Understand what makes your strategy work, and understand what else will affect it before you use it.

Thanks again Pacman. I hope this helps.

--Doc Maher

"Income Trader"

DocMaher Trading LLC

All-Star Commentator

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

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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.

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