Explore Your Options
| Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the STOCKS & COMMODITIES website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C. |
Tom Gentile of Optionetics |
CALENDAR SPREADS
I'm having a hard time understanding exactly how a calendar spread creates profit. Can you explain this technique in language that I can easily understand?
A calendar spread, also referred to as a time spread, is a "delta-neutral" (nearly risk-free) strategy. It is composed of both a long and a short position (hence the spread), using two calls or two puts that have the same strike price but expire on different dates. Ideally, in order to maximize the profit, you would like for the stock to finish at exactly that strike price. In Figure 1, you can see that the maximum profit of the calendar spread pictured is at the $25 level, which is the strike of both the long and short position.
FIGURE 1: RISK CURVE FOR A CALENDAR SPREAD
The concept is pretty simple: Buy a long option that expires several months out, and sell a short option that expires in one or two months. At the expiration of the short position, if the stock is right at the strike price of the options (rendering the short position worthless), the long position still retains most of its original value. You can sell this back on the open market for a profit. This is due to the nature of time decay in the two options. Since most of an option's time decay occurs in the last 30 days before expiration, there's little time decay for options that expire three months out. Your cost in the trade is the difference between what you paid for the long position, less the premium received for the short. You've made a profit because the short position loses more value than the long position over the same period of time.
If you're still having trouble understanding this, think of the long term as an asset, much like an investment property that you've purchased with cash and plan to rent out. Suppose you buy a rental property for $100,000 and you wish to rent it out for one month for $5,000, at which time you plan to turn around and sell it (an unlikely scenario, but read on!). One month later, you put the property back on the market and sell it back to its original owner for $97,000. Did you lose any money on this deal? No! You lost $3,000 on the home, but you pulled in $5,000 on the rent, netting you a $2,000 profit.
Now let's go back to the calendar spread. This is how it works: The long call (the rental property) maintains most of its value in the short time you own it, while the short call (the rent you collected) loses all of its value. When it's time to sell that long call back to another buyer, you're selling it for almost what it was worth when you bought it in the first place. Your profit is the net from the long call, in addition to what you received from the short call, less your initial debit on the spread.
MARGIN ACCOUNTS
Do I need to open a margin account to trade options?
Generally speaking, no. But this largely depends on your broker. Most reputable options brokers will allow you to open a cash account to be able to trade calls, puts, and covered calls. However, since you are not approved for margin, you won't be able to place spread orders in which there is some combination of long and short options. Usually, the minimum balance required for a cash account is $1,000, but again, this will vary as well, with some brokers taking it as far as not requiring a deposit at all! Of course, it's very difficult to make something from nothing. Not even Warren Buffett could pull that off.
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Originally published in the April 2004 issue of Technical Analysis
of STOCKS & COMMODITIES magazine.
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