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 SPREAD QUESTIONS
I have developed some indicators that give a fairly accurate picture of when a trend is over. In other words, when a signal comes, I'm about 70% sure that the trend will either reverse or go flat.
A calendar spread seems like a good tool for trading this kind of opportunity. I know what to do if the market goes against me and the trend resumes and I know what to do if the market goes more or less flat. My question is about what to do if the market reverses enthusiastically and overruns the spread.
Let's say stock QRS has been declining through the month of April, then turns back up and I get a signal on the 25th of the month when the price is at $27. I decide to put on a calendar spread, selling the May $30 call and buying the June $30 call. But instead of going flat, the market takes off, heading for $30 and maybe then some.
If I sit and watch while QRS goes above $30, I'll probably get assigned on the May $30 call and take a loss on the trade. One course of action would be to close both sides of the spread if the stock price exceeds $29.50 or so.
An alternative is to set a stop on the short call, buying it back
if its price increases by more than 50%. Then I could manage the June $30
option alone as a simple long call. What would you recommend?Thanks.
--Richard
Thank you for your question. First, congratulations on your system. I have developed and traded a lot of systems over the years and I know that they require a lot of work and patience. I have also learned that changing market conditions can have a significant impact on results over time. Once I have a winning system, I monitor and fine-tune it. My first suggestion: Keep working on your system, even if you are getting great results now.
As for the strategy selection, the calendar spread is a tool used when the stock is expected to move sideways or gradually in one direction or another. As you know, the trade is created by buying a longer-term option and selling a shorter-term option with the same strike price. The strategy works because of the nonlinear nature of time decay. Options see a faster rate of time decay as expiration approaches. An option with one month of life remaining will lose money at a faster rate than an option with six or seven months left until expiration. In the spread, we want the longer-term option to hold or even increase in value as the short-term option loses value and eventually expires worthless.
Since calendar spreads are designed to make money from the nonlinear nature of time decay, my second suggestion is look at a longer-term call that has more time remaining until expiration when compared to the short call. In your example, there is only one month separating the May and June contracts. Instead, I might look at the September. Then, if I'm right and the May option expires worthless, I can sell another June option, then July, then August.
Another important factor to consider is whether the stock pays a dividend. If it does, there is a risk that a call option will be assigned in order for the call holder to receive the dividend. This will break you out of the calendar spread. So my third suggestion is to look at put calendar spreads as well as call calendar spreads, especially when dealing with dividend paying stocks.
In addition, assignment on the short call is likely any time the option is in-the-money near expiration. So you are correct, you must anticipate that possibility and exit the trade before it happens if you don't want to be assigned. You certainly don't want to be forced into a situation where you are exercising a longer-term call to fulfill assignment on the short-term call. You will lose all of that time value if you exercise the long call. Instead, you should have enough cash in the account to honor assignment or exit the trade before assignment is likely to occur.
One exit strategy is based on the stock price reaching a certain level. In your example, if the stock is at $29.50 and the strike price of the call is 30, the option is 50 cents out of the money (OTM). Exiting the trade at that level would be a conservative approach because assignment is not likely in that situation. On the other hand, 25 cents OTM or less during expiration week and assignment becomes a lot more likely. In sum, make a decision regarding the probability of assignment and if assignment is not the desired outcome, then the only solution is to close out the trade.
A final suggestion is to consider a strategy other than calendar spreads. If your system is picking up a lot of stocks that make big moves, the calendar spread will not work. It works best in quiet or range-bound markets. If your system is based on reversals and stocks that are going to move flat or in the other direction, a credit spread might be the better way to go. For example, if QRS is expected to hold steady or rally from $27, the strategist can sell the May 25 puts and hedge that bet by purchasing the May 20 puts. As long as the stock stays above $25, the puts will expire worthless and the strategist keeps the premium. Then a stop-loss can be placed below the current reversal low (or high) to cut losses for the 30% of the time that the system doesn't work.