Online Trading Academy Article of the Week
Counting the Days – Calendar Option Strategy
by Russ Allen, Online Trading Academy 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:
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:
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%):
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.
We’ll look next 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.
Here we’ll extend the example of a Calendar Spread that I started earlier. These spreads are also known as time spreads or horizontal spreads. They consist of a long option (either put or call) at one expiration date; and a short option of the same type (put or call) at the same strike price, but at a nearer expiration date.
These profit from a difference in the rate of time decay between the short-term option (fast) and the longer-term option (slower). When they are done using the at-the-money strike price as in our example, they are neutral with respect to the price of the underlying. If a higher strike price is used, they are bullish, and with a lower strike, they are bearish.
Our example was using JNPR stock, which was at $26.44. We used calls at the $26 strike, buying the Aprils at $1.27 and selling the Marches at $.86, for a net debit of $.41.
Since the $26 strike price was a little below the $26.44 underlying price at the time, this trade had a slightly bearish bias. On calendars, the maximum profit is always made if the underlying ends up exactly at the strike price at the near-term expiration. In that case, our sold options expire worthless, while our long-term options still retain a lot of time value, now being the at-the-money options. It’s not necessary for the underlying to end up exactly at the strike price for us to make a profit (and really, how often would that happen?).
Here is the JNPR price chart as it appeared last week:
The profit/loss diagram for our calendar spread looked like this:
On the diagram above, we can see that the maximum profit (highest point on the curve, reading off the vertical scale at the left) was around $40; and this would occur at a stock price of $26 (reading off the horizontal scale at the bottom). The red and yellow vertical lines are placed so that they intersect the green P/L curve at the points where it crosses $0 profit, i.e. the break-even points. These were at $25.01 and $27.09. As long as JNPR stayed in that range until the March expiration, the trade would make a profit (assuming no change in implied volatility). If implied volatility increased, the whole P/L curve would move up. We thought that was likely, since implied volatility was very low.
A week later, on March 13, JNPR had moved down close to $25.01 – our lower break-even point. However, a strange thing happened. When our stock reached the break-even point, it was gone. That lower break-even had moved down to $23.47. Here is the way the updated P/L diagram looked:
Because of a drop in price, implied volatility numbers had changed, and the change was favorable for us. The IV of our long April calls had increased more than that of our short March calls. Although the position coincidentally showed current open P/L of zero (the spread was still worth the same $.41 that we had paid for it a week earlier), our eventual P/L at any price was now better than it had been. At this point, we could afford to ride it out, as long as we did not think there was much chance of JNPR dropping below 23.47 at expiration.
What if JNPR did continue downward, so that the price moved out of our “profitability tent?” Could we improve our situation and avoid losses?
Yes, we can. One easy way is to pitch another pole in the tent. In this case, we could have bought another calendar spread – the March/April 24 put spread. This would involve buying the April 24 puts at $.33 and selling the March 24 puts at 7 cents. This would put another peak in our profitability tent at a price of 24. This would move our break-even down to 23.04, far below any price we expected within the next few days.
Here’s how the diagram looked after adding this second calendar:
We have managed to move the minimum price at which we can make a profit down considerably, at very little cost.
This is an example of evolving a position into one that works better in response to changing conditions.