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Today's Featured Article
Calendar Spreads are also known as time or horizontal spreads because they involve options with different expiration months. In this case, "horizontal" refers to the fact that option months were originally listed on the board at the exchange from left to right. At the same time, strike prices were listed from top to bottom. (For this reason, options beyond the outright purchase of a call or put, or the slightly more complex covered call position, are an array of option strategies call spreads.) Simply, it's a strategy that involves buying one option, call or put, and writing (selling) another, resulting in a position that is simultaneously both
long and short option contracts. To establish a spread and be poised to potentially make a profit, both the option purchase and sale are opening transactions and are commonly entered as one package. That is, the option purchase and sale are executed simultaneous with different strike prices and the same expiration is often referred to as vertical spreads.
In simplest terms, a long calendar spread involves buying an option with a longer expiration and selling an option with a shorter expiration. One very favorable point to a Calendar Spread is the value of time decay. Although both options lose time value as time passes, the option you sold loses value much more quickly than the option you bought. Let's take a look at a May/June calendar spread. Here, we are selling the short-term (May) spread, and buying the long-term (June) spread. On Wednesday, April 8th, the Standard & Poor settled around the 822 mark. The next day we initiated the following trade (please note, there is a great deal of monitoring and risk management that goes into
each trade, refrain from initiating any trade examples without consulting us):
Sell May 925x950 call spread
Sell May 725x700 put spread
Buy June 925x950 call spread
Buy June 725x700 put spread
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As you can see, we are buying and selling the same exact strike prices, and we are doing so on both sides of the market. By placing the spreads simultaneously on both sides of the market, we are creating a strategy that is, to a large extent, indifferent to market direction. Rather, this is a pure play on "Theta" or the rate of "Time Decay", which is faster in May and slower in June. Once the May spreads expire, the June spreads still have approximately a month worth of time value. This is our potential profit.
Therefore, if your prediction of a neutral market is correct, the value of your calendar spread will increase as time passes. A calendar spread takes advantage of time value differentials during neutral markets. When the near term option expires, you have several alternatives. If you are still predicting a neutral market, you can hold on to your long position, if there is sufficient time left on it, and sell another short term option against that long position. If you are in calls and you fear that the market may go down, you can close out your long position and take the profits. If you are in calls and you predict a more bullish market, you could just stay with your long position and
take a larger profit in the future. In any of the cases, the cost basis on your long position was reduced by the premium you collected from the option you sold. Beyond the outright purchase of a call or put, or the slightly more complex covered call position, is an array of option strategies called spreads.
Vertical spreads are made up of either all calls or all puts on the same underlying index, with the same expiration months but different strike prices, at a one-to-one ratio. That is to say you might buy one S&P 500 June call with a given strike price, and write an S&P 500 June call with another strike price. It's common in the industry to refer to these two distinctly different parts of the spread -- the long and short options -- as the spread's legs.
Vertical spreads can be either bullish or bearish, depending on how they are put together. For instance, a spread made up of only calls can be bullish, which is what you might expect because of the bullish nature of an outright call position. But a vertical call spread can also be bearish, which you might find surprising. The same goes for vertical put spreads. Some are bearish, as you might expect. But others can be bullish. A simple example of a vertical spread would be to sell the June S&P 500 730 put for 14.40 points and buy the June S&P 500 700 put for 9.90 points. This would give the seller a net credit of 4.50 points. The risk would be the difference between the 730/700 put
spread, which is 30.00 points minus the 4.50 we collected. At the time of this trade the S&P 500 was trading at about 850 on April 16, 2009. As long as the S&P 500 on expiration trades above 730, both options expire worthless and the seller keeps the full credit.
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The iron condor is constructed by holding a long and short position in two different strangle strategies. A strangle is created by buying or selling a call option and a put option with different strike prices, but the same expiration date. The potential for profit or loss is limited in this strategy because an offsetting strangle is positioned around the two options that make up the strangle at the middle strike prices.
This strategy is mainly used when a trader has a neutral outlook on the movement of the underlying index from which the options are derived. An iron condor is very similar in structure to an iron butterfly, but the two options located in the center of the pattern do not have the same strike prices. Having a strangle at the two middle strike prices widens the area for profit, but also lowers the profit potential.
Here is an example of an iron condor on the S&P 500 June index.
Sell June 950 call 13.60 points.
Buy June 975 call 8.90 points.
Sell June 725 put 13.60 points.
Buy June 700 put 9.90 points.
On April 16th 2009, the S&P 500 index was trading around 850. The net credit on the call side of the condor was 4.70 points (13.60 pt. - 8.90 pt.) The net credit on the put side of the condor was 3.70 points (13.60 pt. - 9.90 pt.) Together the net credit from both sides is 8.40 points (4.70 pt. + 3.70 pt.) On a condor spread the risk can only be on one side or the other. Which means that the 25.00 point spreads we have created on both sides of the market has a maximum risk of only 16.60 points (25.00 pt. - 8.40 pt.) As long as the S&P 500 finishes between or at 950 to 725 on expiration all options expire worthless and get to keep the full credit minus any commissions or fees.
All three of these option strategies can be best used in a non-directional market. They all possess the most important aspects of spreads, which is limited risk, while allowing time to work for you.
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About the Author
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William Chieco
is a senior options specialist with Trader's Edge. William began working in the commodities industry in 1997. William's market specialties include stock indexes, energies, currencies, metals and grains. His main trading style revolves around option selling, combining both fundamental and technical analysis. William has managed over 10 million dollars in client equity at any one time. His clients are located in Asia as well as North America. William has educated investors from coast to coast with articles and seminars. He is a contributor to OptionsScholar.com. His main focus is on the S & P 500 option spreads, utilizing a more delta neutral trading strategy with
predetermined risk.
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Special Message from Our Author
COMPLIMENTARY Booklet: Smart Trading Techniques
Trader's Edge is offering a complimentary booklet, Smart Trading Techniques: How to Profit from Time Value Decay Writing S&P 500 Credit Spreads. John Summa, a well-known options trader and advisor, shares his time-value-friendly strategy for trading options on the S&P 500 futures. Why not put his experience to work in your portfolio? Get your copy now! | |
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