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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!

Preview:
In my earlier articles ("Delta Neutral – trading without predicting market direction" and "Options writing strategies: pitfalls to avoid") I wrote about options sellers and Delta Neutral trading. Delta Neutral traders employ various techniques in an attempt to minimize the effect of market direction on their positions. One method of Delta Neutral trading is known as the "Iron Condor". Delta Neutral traders who wish to write options, collect premium, and gain from time decay, would simultaneously sell credit spreads above and below the market and adjust the spreads after market moves in order to keep premiums and deltas approximately equal on both sides of the market.

Volatility:
The "Iron Condor", as well as other option writing strategies, works best when, at the time of inception, Volatility is relatively high. This is because high volatility creates inflated premiums. In fact, in times of high volatility, the farther away from the money an option is, the more overvalued it tends to be relative to a closer to the money option.

"Iron Condor" and other writing strategies do not perform as well when, at the time of inception, volatility is relatively low and thereafter increases sharply. Under such conditions, the options sold could gain value, which represents potential losses to the seller. It is worth noting and remembering that regardless of how high or low volatility is, if at the time of expiration the options sold are out of the money, they will expire worthless, and the trade will be winner. Nevertheless, high volatility, which corresponds to wide movements in the market, increases the probability that the options sold would expire in the money, potentially turning a short spread into a losing trade. It is prudent, then, to be aware of volatility when using options writing strategies and to take proper steps and adjust the trades when appropriate.

The Calendar Spread:
While searching for a strategy for relatively low-volatility conditions, one should take note of the Calendar- Spread. An option calendar spread is a spread in which options are bought and sold in two different months, usually on the same underlying market. It many times consists of selling an option in the closer month and buying an option in a further away month and on the same side of the market. The intention here is to take advantage of the faster time decay in the short-term option, which we sold (options lose time value faster as they near their expiration date).

Unlike its cousin - the credit spread, a calendar spread is often entered at a debit rather than credit. Nonetheless, I view the calendar spread as an option writing strategy. I take this position because I view the calendar spread as a pure play on time decay. The purpose here is not to gain from the market moving in one direction or another, but rather to gain from the faster time decay of the short-term month.

Risk Profile:
Many traders consider the calendar spread to be less risky than a credit spread because the long option we own has more time value. To a limited extent that might be true. As long as the option we sold is out of the money and as long as the two months move in tandem, calendar spreads tend to gain less value than a similar credit spread. There are circumstances, however where this assumption may lead to sobering results if appropriate action is not taken. Please refer to my last article, "Options writing strategies: pitfalls to avoid" or contact me for further information about this specific point.

I do not recommend placing a calendar spreads in markets in which two different months may move in a significantly dissimilar fashion or in some extreme cases have the potential to move in two different directions. This may occur in markets such as the Grain complex or Energy complex, when short term and long-term supply or demand can greatly influence the market. Rather, I think the most appropriate markets for the strategy are those in which different months move in tandem. I will focus my examples on the Standard & Poors (S&P) 500.

It is very important to note that when discussing risk on calendar spreads it is virtually impossible to determine the profit and lost potential in absolute numbers. Sure, one may determine that the risk is limited and one may determine guidelines to assess the risk, but no absolute numbers can be determined. This is because at expiration of the short-term options, which is usually the time in which the trade is unwound and closed, the long-term options will still carry time value. It is virtually impossible to know for sure the value of the longer-term option at expiration of the shorter-term option.

While many factors play a roll in the risk profile of the calendar spread (volatility, timing, distance from the money, and more), two aspects are fundamental to the understanding and management of the risk in any given calendar spread. When dealing with a calendar spread in which the short and the long strikes are the same or when the long strike price is closer to the money than the short strike - the premium paid will constitute the risk. When dealing with a calendar spread where the option sold is closer to the money than the one we bought, the distance between the short strike (the one sold) and the long strike (the one bought) will be a major factor in determining the risk profile of the trade. These two factors will underlie the risk potential of the trade. The examples that follow, and my next articles, will illustrate several different types of calendar spreads. All of the references in this article assume exiting the complete trade at the time of expiration of the near term month. Leaving the long options to expire increases the risk potential significantly and is adverse to our desire to be premium sellers.

The "True calendar":
I chose to present this strategy first because many traders view it as the ultimate calendar spread. In this type of a calendar spread the short options (those sold) and the long options (those bought) are at the exact same strike prices. This spread is initiated at a debit because the longer-term option (the one bought) is more expensive than the shorter- term option (the one sold). Let’s take a look at some real numbers. Please note that the examples that follow exclude commissions and fees. I chose to bring an example from the expiration of the last quarter. I think that looking retrospectively will make it easier for the reader to learn a new concept.

On Monday, September 17^th, 2007, the December S&P contract closed at 1489.80. The October 1500 call settled at 36.0 points or $9,000 (36x250). The November 1500 call settled at 49.2 points or $12,300. The total debit then, at inception, is 13.2 points or $3,300*.

Let’s look at three scenarios. 1) Flat market 2) Bullish market 3) Bearish market

1) Flat Market:
From October 1^st to October 15^th, the S&P traded in a bullish fashion without much interference. Then came Monday the 15^th and everything changed. The market reversed direction sharply and October 19^th , expiration day for the October options, ended with a thud. Friday’s closing bell saw the market approximately 40 points lower than Thursday’s close and the market settled at 1505.8 (for the sake of easier reading I will round the number to 1506.00). At this level our trade expired only 6 points away from market levels at inception. Let’s take a look and find out how our trade faired in this scenario.

The October 1500 call expired in the money and its intrinsic value is 6.0 points or $1,500 (6x250). The November 1500 call settled at 38.1 or $9,525 (38.1x250). If we bought the spread for $3,300 and at expiration sold it for $9,525, the total profit on the spread is $6,225 ($9,525-$3,300)*. This is an almost ideal expiration for a calendar spreads trader and while such terrific results do not occur every time, one can easily understand why some traders adopt the calendar spreads as a main strategy in their portfolio.

2) Bullish Market:
Since expiration brought the market to its knees, it is impossible to know with absolute certainty what the results would have been should the market stayed bullish. It is only possible to estimate the result of the trade if the market indeed kept its bullish bias. Fortunately, we have a reasonable way to do that.

The 1450 call strike price is 56 points below the expiration level (1506-56=1450), 56 points in the money. If the market would have been bullish and expired at 1556, 50 points higher than it did in reality, the November 1500 call would have been 56 points in the money (1556-1500=56). It is reasonable to assume then, that the value of the November 1500 call would have been approximately similar to that of "today’s" November 1450 call – both are analyzed at 56 points in the money (for the purpose of simplification we are not looking at the influence of volatility on the options pricing).

Let’s examine the October 1450 call vs. the November 1450 call and their values.

On Friday, October 19^th, the November 1450 call settled at 73.1 or $18,275. The October 1450 expired, as we know with an intrinsic value of 56 points or $14,000. The total spread then is $4,275 ($18,275-$14,000)*. Since the premium paid at inception was $3,300, we can clearly see that even at 50 points in the money, this calendar spread would have been a winner.

Let’s examine one more scenario yet deeper in the money. For this exercise we’ll use the 1425 October call vs. the 1425 November call. The November 1425 call settled at 93.1 points or $23,275. The October 1425 call carries a value of 81points (1506-1425) or $20,250, bringing the total value of the spread to $3,025*. It is here that we see the spread turning into a losing one. Though a losing trade ($275*), under these circumstances, 75 points move or approximately 5% within less than a month, and considering the first and second scenarios, one could see why many traders are attracted to this type of trade and its risk/reward profile.

3) Bearish Market:

Using the same logic I outlined above, we can try and deduce potential results for the trade under a bearish market scenario, by using strike prices above the market. The first thing to note is the loss potential if the market loses ground drastically and enters a sharp down momentum. Under that scenario, both options would lose most of their value and while the November call would always retain some time value until expiration, the spread between the options would narrow, representing a loss. For example, in order to estimate a loss in the uncommon but nonetheless possible event of a 13% (approximately 200 S&P points) correction down, we would look at strike prices that are 200 points above the 1500 strike price.

On Friday, October 19, 2007 the October 1700 call expired worthless. While the November 1700 call settled at 0.10 or $25. We can deduce that if we sold the October1500 call and bought the November1500 call, and the market was 200 points lower near expiration, the spread between the options would have narrowed and, in effect, represent a loss of effectively the complete premium paid ($3,300)*. It is worth noting that under this scenario, instead of closing the long November option, we would hold it in case the market turns around. For the risk of losing the 0.10 points ($25), it is worthwhile to hold the call.

Now that we know the worst-case bearish scenario, let’s take a look at a bearish move that is lesser in volume. Let’s look at strike prices that are 25 points above the 1500 strike price, which will represent a downward move of 25 points or a little more than 1.5% from the market level at inception (1490.0).

Let’s refresh our logic again. We bought the November 1500 call. On Friday, October 19^th , the S&P market settled at 1506. The November 1525 call, which is 25 points higher than our 1500 call, settled for 24.2 points or $6,050. If the market was to settle 25 points lower (at 1481), our November 1500 call would very likely be valued near the same as the November 1525 call since it would have been the strike which is 19 points above the market level. Since the October 1500 would have expired worthless if the market settled at 1481, our profit on the spread is the premium of the November call we own, vs. the initial debit we paid to enter the spread. In this case our profit would have been approximately $2,750 ($6,050-3,300*).

Repeating the same process to estimate results on a 3% down move (50 points), we would look at the November 1550 call. Since the October 1500 call would have expired worthless, our profit or loss would be determined by comparing that value to our original debit. The November 1550 call settled at 13.6 points or $3,400* for a small positive balance, suggesting once again that even under some adverse conditions, the calendar spread offers a strong, inherent risk management mechanism.

Conclusion:
It is important, when trading options, to be keenly aware of the volatility levels in the market and to be pragmatic as to the choice of strategies. Writing options when volatility is low is not recommended because increasing volatility raises the value of the options. The risk/reward profile of the calendar spread is different than that of a credit spread. It offers limited risk and holds its value well even as volatility increases. The calendar spread is often times initiated at a debit rather than credit, but is viewed however, by many as a writing strategy since it aims to gain from time decay. In my next articles I will describe other types of calendar spreads, such as the diagonal spreads, strangle calendar spreads, the reverse calendars and others.

* Excluding commissions and fees.

There is substantial risk of loss in trading futures options. Only risk capital should be used.

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!