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Author: PeterEidson Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 11006  
Subject: Re: Compounding Small Profits, Part 2 Date: 3/25/2001 2:10 PM
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I received eight private emails that expressed an interest in calendar spreads. The following is lengthy, but it contains the essentials of designing calendar spreads.

A calendar spread is a sophisticated option strategy, yet, at the same time, really easy. These spreads offer a profit zone that ranges above and below the strike price, can be constructed to reflect your bias on the underlying (bullish, bearish or neutral), and for short or long time horizons. These features allow you to design a spread that has high probabilities of success with a low risk. I limit my maximum risk to less than $2.00 per contract.

Last week YHOO offered a very attractive bullish Jan02/Jul01 calendar spread with high odds-of-success (3.6 to 1), a very wide profit zone ($37.35 to 105.60), and a cost of $1.30 per contract.

Reasons for doing a calendar spread:

1. Not interested in watching minute-by-minute market activity
2. Not a lot of trading capital, or not much remaining
3. Not as confident in your trading ability anymore
4. Like to sleep well at night or go to Utah for a week
5. Like a limited risk strategy with potential high returns
6. Like to make money, even when you are wrong

Criteria For Doing a Calendar Spread:

Writing about calendar spreads gives me the opportunity to share what I've learned and have it reviewed by some knowledgable option traders on the board. This is a good way to explain some "option basics" for the beginner trader while at the same time offer a more sophisticated trade for those of you who have been burned by straight directional trades. I will try to give a fair amount of explanation to each of my points below, but if you still don't understand a point, go dig out some books. Sometimes one author will explain something in a complex manner, while another makes it sound so simple.

Now on to the topic at hand. The calendar spread that will be discussed is on XYZ Jan02 and Jan03 puts with a strike price of $80. XYZ is a fictitious stock, but the data is based upon real data of a highly liquid stock and options. Long term spreads are used because they are easier to understand and explain.

Definition:

The calendar spread is also called a time or horizontal spread.

Components:

1. A short position
2. A long position with a longer time frame
3. All calls or all puts
4. The same strike price is used for both legs
5. Cost is minimal
6. Maximum Risk is the cost of the trade
7. Depending upon your time frame, the reward can be very high, usually 2 to 8 times your investment

Criteria for calendar spreads

1. Find a stock that has been recently slammed and was at a MUCH HIGHER point in the past.
2. Find a stock where the shorter-term option has higher volatility than the longer-term option.
3. Find a stock where the current implied volatility (20 day) is lower than the average yearly historical volatility.
4. Determine the most appropriate time frame to trade.
5. Determine the most appropriate strike to use.
6. Select the number of contracts that are optimal for your trading plan.
7. Learn how to calculate your risk to reward using different strikes and time frames.
8. Find the approximate value of your spread at expiration if you are wrong.

Maximum reward is obtained when the stock closes at the strike price you chose at expiration of the shorter month. In this case, the January 2002. In this example I will buy a XYZ Jan03 80 Put and short a XYZ Jan02 80 Put. I prefer to use puts because the prices are usually cheaper than calls and the effects of random-assignment can be turned to your advantage. If XYZ closes at 80 on expiration day of Jan02 Put (short leg), then the Jan02 put will expire worthless and you'll still be long the Jan03 Put, which is "at-the money" with one year left to expiration. You can either sell the Jan03 Put, roll forward, or convert it into a Bull Put Spread. This part troubles a lot of people and prevents them from using calendar spreads.

VERY IMPORTANT CONCEPT:

It is very important to understand that the current price of the Jan02 "at-the-money" option is a good approximation for what the Jan03 80 Put will be worth in January 2002 if XYZ is at 80. As of this wring, the price of the Jan02 40 Put has almost a year left and is currently worth about $6.00. If XYZ closes at 80 on Jan02 expiration, the 80 strike price would be "at-the-money" and worth at least $6.00, probably more.

Criteria for calendar spread:

1. Find a stock that has been recently slammed and was at a MUCH HIGHER point in the past.
That's not too hard to do these days. Almost any stock in the Nasdaq 100 can be used.

2. Find a stock where the shorter-term option has higher volatility than the longer-term option.
When a stock is slammed the implied volatility (IV) tends to dramatically increase, especially for the near-term option. This IV spike produces a significant volatility skew in which the near-term option becomes much more expensive that the long-term option. Remember, it is the same drill as with stocks: you want to buy low and sell high. With calendar spreads, you're buying low volatility and selling high volatility.

Understanding how to play volatility will greatly increase your odds for success in any option trade. Volatility is a main component in option pricing and if you don't understand it, you need to. Volatility is the measure which the stock is expected to move up or down in a given period of time.

There are two types of volatility: historical and implied. Historical volatility is calculated based on the actual stock price changes in the past. Implied volatility is what the market-maker believes the stock will move and is calculated using the Black-Scholes Option Pricing Model. Implied volatility (IV) is a key component that determines the price of an option. When implied volatility is higher relative to historical volatility, the more expensive the option. For this reason, you want to be a buyer of low volatility and a seller of high volatility. With XYZ, months farther out have lower implied volatility than the closer months. Most trading platforms give you implied volatility of the option. Therefore, XYZ remains a candidate for this trade because the implied volatility of the January 2002 options (short leg) is more than the January 2003 options (long leg).

3. Find a stock where the current implied volatility (20 day) is lower than the average yearly historical volatility.
Don't confuse this with #2 which discusses differences in volatility between the months. If the volatility as a whole is relatively low in relation to where the volatility has been in the last year, your position will benefit from a rise in volatility. Historical volatility over the last year has ranged from 0.42 to 0.69, and currently is at 0.43 at the low end of the range. Therefore, the price of our options will increase in value if volatility increases.

The long XYZ Jan03 80 Put will rise in value if the volatility is higher than the current volatility because implied volatility is a main component of option pricing as discussed above. If volatility at expiration is the same as it is currently, then our "guesstimate" of $7.40 is a good one. I like to be conservative, so I would base my risk/reward calculation using this number, knowing that my odds are greatly increased if there is a rise in volatility. If you don't have the ability to get this information, don't worry, it is not as important, it just gives you a little bit better edge.

Pay particular attention to the IMPORTANT CONCEPT above and go back and try it with other stocks that you trade. Don't try this out without the benefit of the criteria 4 through 8. Pick a book on options and read everything you can about volatility--your bank account will thank you.

4. Pick a time frame you are comfortable with.

This is a subjective one, but there is no mystery here. The longer the time frame the less sensitive the spread is to fluctuations in the stock. If you would like to just buy an investment and tuck it away, then you should use a long time frame like the Jan02 and Jan03 as previous discussed. If you want action now, then use a shorter time frame. The shorter the time frame, the more the potential reward as an annual percentage, but with that comes more risk. As they say, "there ain't no free lunch."

5. Pick a strike you are comfortable with.

No mystery here either, remember, you are betting that the stock will close at or near your strike price at the expiration of the shorter leg. If you were to use March and April instead of the Jan02 and Jan03, it is common sense that you wouldn't use 80 as your strike price, unless you think the XYZ's could close at 80 in the next 4 weeks! The strike you choose will be dependent on your market outlook for the next month if using the March and April options. If you think the XYZ's will stay flat, you might choose a 50 strike, if you were moderately bullish you might choose 55, really bullish and you might select 60! The cost of the spread decreases as you move the strike farther above the current price of the stock. The cost of the Mar-Apr 50 Put calendar spread would cost $1.60 or $1600 for 10 contracts versus $1.20 ($1200) for the spread using a 60 strike. However, which strike has the greater probability?

I'll leave that for you to decide. When you go out longer term, your capital is used to put on various positions with greater odds-of-success and somewhat less of a reward, therefore, increasing my changes to be right. Right now, I'm using short-term spreads because of the market's volatility.

6. Select the number of contracts you are comfortable with.
I recommend at least 10 contracts when doing this strategy. The reason is that most brokers charge you a minimum ticket, and with the cost of the spread so cheap, it's not worth doing less than 10, or commissions will play a real factor. It also gives you some room to make some adjustments, a topic that can be covered at another time.

7. Study different strike and time frames and calculate your risk to reward.
In the case of the Jan02/Jan03 puts with a strike of 80, we determined our maximum reward was $7.40, lets say $7 to make it easier to calculate. The cost of the spread would be $1.60 using the "natural spread". The natural spread is buying at the ask and selling at the bid, which the market maker is obligated to fill at. However, you can always squeeze a little out of each leg, and I would conservatively assume we could get this spread down to $1.40 or $1400 for 10 contracts. Now divide $1.40 into the guesstimated actual reward of $7 and you get 5 to 1 odds! That means you make a 500% return in about a year if XYZ go to $80.00. Maybe you would be more comfortable with a projection of $70.00, if so then use the prices for the 70-strike, which would be a cost of $2.30 for the natural spread or about a 3 to 1 odds. Notice how your reward drops as the strike price drops closer to the actual price of the stock.

8. Find approximate values on your spread at expiration in case you are wrong about the stock.

You can do this by looking at current option prices and using those prices as approximations for what options will be worth in the future by changing the time frames and strike prices. If you decide on the XYZ Jan02/Jan03 80 strike, then how much would your spread be worth if the XYZ's only get to 60 or 70? To figure this, look at the current prices of the Jan02 options to approximate the value of your '03 leg at expiration in Jan02.

If the XYZ's only get to 60 instead of 80, your short Jan02 80 Put is worth 20 points, ouch! You would have to buy them back and you would be down $20,000 plus your initial investment of $1400. Don't panic, your Jan03 80 Put would be worth at least 20 points too, plus 1 year of time value, so all is not lost. You probably could get $1 of time value on the Jan03 put so your total loss would be about $400 ($1400 cost of spread less $1000 which would be the sale of spread in Jan02). Worst-case scenario-- if the stock is "put" to you, in other words you are assigned the stock, simply exercise your long put and move on. You have no extra money at stake and that is truly the worst case. You would lose $1400, the cost of the spread.

If the XYZ's only goes to $70.00 - then the short Jan02 80 Puts would be worth $10 or $10,000, but your long 80 puts would be worth approximately $12.80 or $12,800, which is the current price of the Jan02 60 Put. This is the approximation you must master, by using current prices to project the value of your long leg at expiration of the shorter-term option. If the XYZ's get to 70 then your 80 puts would be 10 points in the money. Today, the current strike that is 10 points "in the money" would be the 60 strike because the XYZ's are currently trading for about 50. Looking at the current prices of the Jan02 60 Puts, which are 10 points "in the money", you would determine that your long 80 put would be worth about $12.80. Subtracting the $10 to buy back the short leg, your profit would be $1400 ($12.80 for the price of the long less $10 price of the short leg less $1.40 cost of the spread originally, times 1000 for 10 contracts). You made 100% in a year and you were 10 points off your projection, not bad.

Really study and understand how to determine the value of your spread at expiration and you will see that this is a worthwhile, low risk, high reward kind of trading. Pay particular attention to #8 and go back and try it with other stocks that your trade.

While in Utah, I re-read The Selfish Gene, by Richard Dawkins. In Chapter 5 Dawkins discusses Evolutionary Stable Strategies (ESS) of survival and uses Game Theory to illustate his points. It was like I was reading about option trading. Now my curiosity is piqued as to whether modern game theory may point the way to develop and refine trading strategies that'll both enrich me and give me high odds of surviving.

Be successful out there!!
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