Options

Counting the Days – Calendar Option Strategy

russallen200
Russ Allen
Instructor

At times when options are cheap, it seems like a good idea to buy them. But when they are cheap, it’s because the option-buying public doesn’t believe there will be much price movement in the near future.

What if you agree with them – is there any way to benefit from a situation where options are cheap, even if the underlying doesn’t move after we buy them?

Actually, yes. One way to do just that is by using a calendar spread. In this spread, we buy an option with a strike near the current price, with more than a month to run. We then sell an option at the same strike, but with a nearer-term expiration. The profit comes from the faster decay of the near-term option compared to the longer-term one. If price sits still, we profit to the extent of the difference in time decay. If price moves more than a little, we’ll have to shut it down early, but risk is limited.

A nice bonus on this trade, and the reason we might select it in this situation, is that it benefits substantially from an increase in implied volatility going forward. This is because there is much more time value in the long-term options we own than there is in the near-term options which we are short. A future increase in implied volatility will increase the value of all options; but it will increase it the most for those options that already have the most time value. That means more distant options, like the ones we own.

Here is an example. On March 6, Juniper Networks (JNPR), at $26.44, was in a sideways pattern. There was resistance above at around $28 and support below around $25. Implied volatility was near its low for the past year (meaning that options were very cheap). Here’s the chart:

March 6, 2014 Juniper Networks (JNPR)

This is a stock which has a fairly high average volatility (around 40%, or three times of the S&P 500), but is currently at a low level based on its own history.

We could have bought a March-April 26 calendar as follows: Buy to open the April 26 calls at $1.27, and simultaneously sell to open the March 26 calls at $.86. This resulted in a net debit of $1.27 – .86, or $.41 per share. The plan would be to hold the position until the expiration of the March options in two weeks. At that time all of the time value in the March options would be gone for sure. Assuming that they were not in the money at that time they would be worthless. The April options we would still be holding, however, would still have a month’s worth of time value remaining. Using our option diagramming software, we could see that with price and implied volatility remaining constant, we would have a profit of around $.22 on our $.41 investment.

Here is the option payoff graph:

JNPR Calendar Spread 1 - Options Payoff

Breakeven prices on this trade were at $25.01 and 27.09. If JNPR stayed in that range for a couple of weeks, as we expected, then the trade would make money, assuming no change in volatility. If JNPR moved out of the range, then the trade could be a loser, but total risk was limited to our net debit of $41. The probability calculator indicated a probability of just over 50-50 that price would remain within the range. Since probability calculators can’t read charts and we can, we thought the probability of profit was greater than 50-50.

Sounds pretty ho-hum, and it was – assuming no change in volatility. If implied volatility did rise from this extreme low, though, then things would get interesting.

As recently as January, JNPR’s implied volatility was at 40%. If it should reach those more normal levels, our payoff would improve quite a bit.

Here’s the payoff chart assuming a 30% increase in implied volatility (from 30% to 39%):

JNPR Calendar Spread 2

With the volatility increase, our maximum profit increased from about $41 to about $70 on our $41 investment. Our break-even prices moved out to $24.22 on the downside and $28.06 on the upside (compared to $25.01 and $27.09).

Much more interesting.

Next time we’ll look at adding more layers to the calendar strategy to improve its potential. We’ll also discuss making adjustments to the calendar once it’s in place to adjust to changing conditions. We’ll find that our ho-hum strategy can be made quite exciting.

For questions or comments on this article, contact me at rallen@tradingacademy.com

Disclaimer
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.