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 |
ASSIGNMENT ON CALENDAR SPREADS
I was wondering if there is any possibility that an in-the-money short side of a put calendar would not get assigned on expiry. Or is the short side always assigned automatically?
The calendar spread is a strategy we use a lot, and understanding when assignment can occur is an important part of this trade. First, let's review the strategy. To create a calendar spread, the strategist buys a longer-term option and sells a shorter-term option. Both options have the same strike price. The trade can be created with either puts or calls. Puts can be used when the strategist has a downward or bearish view on the underlying asset. Calls make sense when the strategist is bullish on the underlying security.
The idea is for the longer-term option to retain most of its value, and maybe even increase in value, while the short-term option wastes away due to time decay. The strategy works because short-term options see a greater rate of time decay when compared to longer-term options. If the short option expires worthless, the strategist keeps that premium. Then, they can sell another short-term option, exit the trade, or simply hold the long option.
Ideally, the underlying asset will remain range-bound or trend only modestly in one direction or the other. A sudden move in either direction can create problems: If the stock makes a dramatic move in one direction, the longer-term option can lose a lot of value and offset any gains from the sale of the short option.
For example, if XYZ is trading near $45.00 a share, a calendar spread is created by purchasing a January 2006 40 put for $3.50 and selling an October 2005 40 put for $1.50. The trade won't work if the stock rallies and the value of both puts falls to zero. In that case, the loss ($3.50) for the long put is greater than the gain ($1.50) from the sale of the short put. On the other hand, if the stock trades to $40.50 at October expiration, the short put can expire worthless while the long put might have increased in value. Then, the trade profits from both the short and the long puts -- an ideal situation for the calendar spread holder.
If, on the other hand, XYZ falls to $35.00 at expiration, both options increase in value. As expiration approaches, assignment becomes more likely because the option holder will exercise their right to sell, or "put" shares of XYZ to the option writer at the strike price: $40.00 a share. The put owner has an incentive to do this because shares can be purchased for $35.00 in the market and sold (by exercising the put) for $40.00. This forces the spread holder to buy the stock in the market for $40.00. Then, unless they want to hold it, they can either sell in the market for $35.00 or exercise their put and sell it for $40.00-a loss occurs either way.
Therefore, the answer to the question is, the short side of a put calendar will be assigned at expiration if it is in-the-money. If it happens, the strategist is forced to buy the stock at the strike price or to fulfill assignment by exercising the long put of the spread. In order to avoid this possibility, rather than facing assignment, the strategist is usually better off closing out the spread or rolling it down to a lower strike price prior to expiration.
TO SKEW OR NOT TO SKEW
What is your position on the value of skews in calendar spreads?
Time skews can be valuable when trading spreads. A time skew occurs when the implied volatility [IV] of options that expire during one month is different than the IV of options that expire during a different month. The most common time skew occurs when the short-term options have higher IV than the longer-term options. For example, options that expire in December 2005 might have higher implied volatility than those that expire in April 2006.
Since IV is a determinant of options prices, this type of time skew indicates that the short-term options are more expensive relative to longer-term options. Therefore, in a calendar spread, which involves selling short-term options and buying longer-term ones, a skew can be a positive factor for this trade.
More important, however, the direction of the stock will dictate the success of a calendar spread. Sometimes, a time skew can develop ahead of an important event such as an earnings report. That event can cause a large move in the stock and push the price through the strike price of the option. For example, a negative earnings report can cause the stock price to plunge through the strike price of a put calendar spread, pushing the options in-the-money, which (as we noted in the previous question) can create problems for the spread holder. In sum, I like skews but they are not the most important thing to look for with calendars. A dead stock and low volatility work well -- consider skews as the icing on the cake.
Originally published in the January 2006 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright
2005, Technical Analysis, Inc.
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