will make $800 on his December $64 put, but lose the $300 premium he paid for the October put, meaning a net profit on the trade of $500. This is less profit than selling naked. But by purchasing the October put, the trader gains considerable protection on the downside. Protection is primarily against a sharp, sudden ‘black swan’ kind of move. If the market drops quickly, volatility will spike in the options, meaning values will most likely increase. With naked options, that increase in value most often means the trader must exit the position and chalk it up as a loss. That is not so likely in a calendar spread.
In the event of a rapid decline in crude oil prices, the December $64 put would most likely gain value. But the October put would gain as well, albeit not as much. In essence, the calendar spread slows the rate of loss. The trader’s risk is determined only by the time difference between the two options. That will hold true until the October option expires, leaving the trader naked the December. However, by this time, the value of the December put will most likely have eroded to nominal levels. The high level of protection of the calendar spread is one reason we suggest it as one of the few recommended credit spreads.
Downside and risk to a calendar spread The downside to the calendar spread is a slower rate of realized returns. While potential losses accrue slowly, so do potential profits. Writing a calendar spread means staying in the trade longer, because one must often wait until closer to expiration to take profits. Waiting is not always necessary when writing naked.
The risks of a calendar spread come primarily after the first long option has expired. While the spread between the two options can increase as the near-month option (October 55 put) nears expiration, a trader is covered against a move into the money all the way through expiration. Yet in the days between the expiration of the October option and the expiration of the short December option, a trader is left naked the December puts. In these forty or so trading days, the December put is left exposed.
Why wouldn’t a trader just choose to write naked in the first place? Aside from the margin considerations, the calendar spread protects the option during the critical time when it has a higher chance of increasing in value. With 40 trading days left on the December option, unless crude oil prices are rapidly approaching the $64 level, chances are the option will be substantially less in value and losing more each day. There is a very high probability that an out-of-the-money option with fewer than 30 days remaining until expiration will expire worthless. There is also a very low probability that the option will increase much in value, assuming it is still a good distance out of the money. A move in the underlying that could have caused the option to double or triple two months ago, might hardly move the value at all at this late time.
Risk should be managed according to premium value. In the case of a calendar spread, the difference between the option values should be monitored. If the difference doubles from the point at which the option was sold, conservative investors should consider an exit.
Think of a calendar spread as a spacecraft using a booster to get out of the atmosphere. The booster rocket (long option) keeps the craft steady and gets it out of the danger of the atmosphere and into orbit. Once it gets there, the spacecraft can drop the booster and get to its final destination under its own power. This is how your short option uses the long option in a calendar spread.
Use of the calendar Calendar spreads are useful in markets where same-month spreads are not wide enough to write a bull put or a bear call spread. The calendar can provide equal, if not greater, coverage of risk and is an attractive alternative as long as the premium credit is right. Often, it will come down to what the market is offering. Volatile conditions, such as those experienced in many markets at the time of writing, can offer prime opportunities to write wide calendar spreads.
Like a golfer selecting the right club for his shot, the option seller must select the right strategy for existing market conditions. In this regard, the calendar spread can be a valuable club to have in your bag.
Q: When I talk to my colleagues about selling options, they all seem to have an opinion. What is the biggest misconception among new option sellers?
A: Without a doubt, it is that the market has to move in their favour for them to make money. Most investors new to option selling are still operating under the old mindset in which they must try to predict market direction (‘I buy stock because I think it is going to move up in price.’) New clients who look at their statement and see calls or puts sold will often say, “I see we sold puts in oil – so we want it to go up, right?”.
The answer is, yes and no. Yes, it would be great if we sold puts and the market moved higher. But it certainly doesn’t have to move higher for your short put position to make money. On expiration day, it won’t matter if the price of the underlying moved up, stayed the same or even moved down somewhat. As long as the price of crude oil isn’t below your strike price, that option is going to expire and you are going to keep the premium.
The underlying moving quickly away from your strike is usually the ideal situation, because it generally results in faster decay of the option’s value. But this doesn’t happen all the time and might not even happen most of the time. You do not know what the market is going to do. By selling an option, you create many scenarios where you can make money, and only one scenario where you can lose. The market does not have to move in your favour for you to make money.
Michael Gross is an analyst with Liberty Trading Group/ OptionSellers.com. Mr. Cordier’s and Mr. Gross’ book, ‘The Complete Guide to Option Selling,’ 2nd edition (McGraw-Hill, 2009) is available at bookstores and online retailers. They can be reached through their website at www.OptionSellers.com.
Do you have a question for Michael or James? Email options@YTEmagazine.com
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