Q&A
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.
Leaping Into Calendar Spreads?
I see some Leap options are not that expensive given the amount of time they’ve got — about two years. There are 23 months you can sell against it. That’s got to be a good trade. Where am I wrong? I know there must be things that I haven’t properly thought through.
For example, I’m looking at a calendar spread with 2011 leaps. The far month (January 2011) costs me about $4 to enter, and the near month (February 2009) brings in about 70 cents. Is this a bad idea? What are potential pitfalls?
Long-term Equity Anticipation Securities, or Leaps, are option contracts with one or two years of life remaining. Many of the more actively traded equities, exchange traded funds (Etfs), and indexes have Leap contracts available and they make great tools for certain option strategies.
In your example, the Leap contract is used in a calendar spread. Similar to a covered call, the calendar spread is designed to generate income by selling calls. In the covered call, one call option is sold for every 100 shares of stock. In a call calendar spread, the strategist buys calls and also sells the same number of calls with the same strike price, but with less time remaining until expiration.
For instance, I might buy a call option that expires in June and sell a call that expires in March. Both calls have the same strike price, but the calendar spread generates profits from the fact that short-term contracts lose value faster than longer-term ones.
While time decay is an important factor to consider when creating a calendar spread, the price of the underlying asset (stock, index, or Etf) is very important as well. For the calendar spread to work, the underlying must move within a range and not be too far from the strike price of the call options.
If, for instance, I am moderately bullish on Xyz and the share price is near $45, I might create a calendar spread by purchasing the June 50 call for $3.00 and selling the March 50 call for $1.50. The cost of the spread is $1.50. Ideally, the stock will gravitate toward $50 per share by March options expiration. If Xyz settles exactly at $50, the March contract expires worthless and the June options might see some appreciation. If so, the strategist has a profit on both contracts.
The risk from the calendar spread is from a dramatic move higher or lower in the underlying asset. A substantial drop in Xyz might result in both option contracts losing value and, unless the position is closed out, both contracts expiring worthless. If so, the strategist loses the $1.50 debit paid to enter the calendar spread.
A substantial move higher poses a problem for the calendar spread as well. If Xyz moves above $50 as expiration approaches, the short call will be at risk of being assigned. If it is above $50 at expiration, assignment is assured and the strategist is taken out of the spread. While the long-term call can be used to cover the assignment on the short-term call, it will probably be better to handle the assignment with Xyz shares because the longer-term option still has time value. If it is exercised to handle the assignment of the short-term call, the time value is lost. In sum, a significant move higher in Xyz will take the strategist out of the call calendar spread and probably result in a loss on the trade.
If a significant move higher or lower in the underlying asset creates problems for the calendar spread trader, Leaps are not always the best choice. While the long-term contracts allow the strategist to continually sell short-term contracts over a period of years and generate a nice income stream, there is also more time for the underlying asset to make a dramatic move in one direction or the other. So, before using Leaps, the strategist must feel confident that the stock will stay rangebound for many months or even years.
Sizing Up the Small Cap Indexes
Which is better for spread trades, the iShares Small Cap Index Fund (Iwm) or the Russell 2000 Small Cap Index (Rut)?
The iShares Small Cap Index Fund (Iwm) is an exchange traded fund designed to move in a similar fashion to the Russell 2000 Small Cap Index (Rut). The index includes 2,000 of the smaller companies that trade on the US stock exchanges. Iwm is roughly equal to a 10th of the Russell 2000. As of this writing, the index is near 430, and therefore, the exchange traded fund is near $43.
Option contracts are very actively traded and liquid in both the Iwm and Rut. Both are great tools for traders looking to trade broader trends in the US equity market. Since small caps tend to be more volatile than large caps, the Russell index tends to move around a little more than large-cap benchmarks like the Standard & Poor’s 500 and the Dow Jones Industrial Average (Djia).
There are several important factors to keep in mind when choosing between the Iwm and the Rut. First, since the Etf is a smaller value, option premiums will also be at lower prices, which is more appealing to traders with smaller trading accounts.
The settlement of option contracts on the Etf and the index is different as well. Like stocks, the Iwm settles for shares and assignment of options involves the physical delivery of shares. Rut options, on the other hand, settle for cash. Assignment involves the transfer for cash equal to the difference between the strike price of the option contract and the settlement value of the index.
Finally, like most other indexes, the Russell 2000 settles European style, which means that exercise and assignment can only happen at expiration. Etfs and stock options settle American style and therefore options on the Iwm can be exercised at any time prior to expiration. For some trades, where the strategist doesn’t want to run the risk of early assignment, the Russell 2000 Small Cap Index might be preferable to the exchange traded fund.
