Jordan
Craw
 		 You don’t have to travel far into the option world to hear statistics like “70% of all options expire worthless” bounced around. Does this mean every option that expires worthless is a losing position? Of course not! Having said that, we can use this statistic to our advantage.

Now we all know that selling uncovered options can be very dangerous, especially for beginners. The argument for using naked option strategies is that when using options close to expiry, the premium received coupled with time decay will more than cover for any large movements against the position. While this is true, it is not a trading method for the faint hearted.

A far safer strategy is to play off the inherent difference in time decay levels between options with different expiry dates - known as a calendar spread. As time decay works exponentially, options lose one third of their value in the last 30 days to expiry. Knowing this, we can sell options with the intention of them expiring worthless and cover them with options that will lose far less value over the same period.

While they can be applied directionally, calendar spreads are most easily applied to sideways market movement. One trait typical of stocks that have fallen significantly over-night, is a period of sideways movement as the stock consolidates. This can last anywhere between a few weeks to a few months, sometimes more.

Who knows a stock that has fallen recently? Even if you can’t name any, one thing is for certain. Stocks will rise and stocks will fall. Why not be able to profit from both these situations as well as the sideways periods in between!?!

Below is a chart of AMP after its drastic fall back in 2003. Notice that the stock then trended sideways for 3 months. There was a calendar spread during this period that doubled its value in 6 weeks. How many people do you know can double their money in sideways markets I ask you? Try telling that one to friends over dinner and watch the looks of confusion appear.


AMP Daily Chart

click chart for more detail

The recent fall on NAB, while not as significant, is potentially a similar example. Most stocks will trend up slightly before continuing a sideways trending period. Looking at the NAB chart, this is exactly what has happened so far.

Long Calendar spreads can be constructed with either puts or calls. In many cases puts are a good choice as any further falls will benefit the long put not only via the stock price movement, but also a likely increase in implied volatility.

Choosing the options to use in the construction of a calendar is a matter of considering:

  1. The expected time frame of the sideways move.
  2. Time to expiry of nearest month options.
  3. The cost of the long position vs. the short.
With a sideways market view, it stands to reason that at-the-money options are used. In the case of NAB a May ‘04 29.50 put was sold and an October ‘04 29.50 was bought. May was an easy choice as it is the closest strike available and falls close to the 30 days from expiry mark. Placing the long put at October ‘04 expiry gives plenty of time to take in premium and then sell that option, cashing in its remaining time value.

NAB 29.50 May/0ctober 04 Calendar Spread

click chart for more detail

Remember that the above risk graph shows only the first month of the strategy. Each month that premium is kept, the maximum risk on the position decreases. The risk graph from OptionGear above calculates the position’s value at expiry using a model price figure for the long option at the short option’s expiry. The maximum risk in a calendar spread using options with the same strike is simply the difference between the price paid for the long options and the price the short option/s were sold for.

While the risk/reward does not look very healthy on the risk graph above, technical stops based on the high of the gap day and the most recent swing low would allow the position to be managed with very little downside. Note that part of the reason this construction was used is that the break-even lines fall on and just outside the stop loss points listed. A breaking of either of these two points would signify a potential resumption of a trend.

If the stock did start to trend, the trader could consider holding the long put if they had a bearish view. If they have taken in enough in premiums over the months previous, this would effectively be a free trade.

Without going into too much detail, there is yet another approach for a trader whose view has turned bullish. Along the lines of last week’s article, an October 04 put with a higher strike could be sold to create a Bull Put Spread. As you can see calendar spreads are a useful and flexible way to benefit from sideways market movement. As well as a way to own a put or a call for free to then benefit from a trend continuation.

The key element to option trading is to have a clear game plan covering the major situations that may arise during a trade. Having analysed these elements first allows decisions to be made on the initial validity of a trade and the best follow up action in case the market environment changes.

Until next week, happy trading…

Jordan Craw