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Yola Edwards

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The vacation option

Yola Edwards

Regardless of the health of the economy or the general market direction, securities move at their own pace and in their own direction; up, down or sideways. Utilizing option strategies properly can potentially help reduce risk, increase your profitability, by helping you navigate the market and maintain a greater degree of control over your investments and respond to existing market conditions rather than waiting for an upturn or downturn. The chart below depicts the more popular option risk management strategies best suited to meet an investor's anticipated price movement.

If you anticipate a sideways market you might employ the vacation option strategy. A successful vacation is being able to relax while getting the most for your money in the little time you have available. The so-called vacation trade also known as the time, horizontal or calendar spread utilizes the same principles.

A horizontal calendar spread is one that uses calls or puts with the same strike price but different expiry dates. It is viewed as a short-term neutral strategy, but is generally longer-term bullish or bearish as investors typically use a slightly out-of-the-money (OTM) strike price, which in turn assumes the bullish or bearish bias through to the expiration of the first option. A neutral market position would use at-the-money (ATM) or slightly in-the-money (ITM) options. The position is created by purchasing a longer-term option and simultaneously selling a shorter-term option with the same strike price.

Vital to the success of the option vacation strategy or calendar spread, are time and time decay, with time value being eroded faster on the short-term option then the value of the long option at the end of the trade. The aim is to sell short-term call or put options with higher implied volatility (IV) and buy longer term call or put options with lower implied volatility, paying as little a debit as possible.

In the event the short option expires worthless, the investor can sell another near-term option with the same strike price to create a second calendar if their outlook is still short-term neutral or sell an option with the same expiration, but different strike price to create a vertical spread if a more modest directional move is expected. Alternatively, the investor can simply remain long the further out option if the outlook is more bullish or bearish.

The key to successful calendar spreads is to be able to roll forward to capture more time premium, eventually erasing the initial debit and create a credit in the account. Do not leg onto a spread, meaning do not try to execute the orders separately as you are then exposed to any sudden adverse market movements. Always enter it as a spread order with the strike prices and months and the desired debit spread limit. The investor must realize also that there are times when these strategic order entries may not actually be able to be executed due to market forces.

Calendar spreads are limited risk positions with unlimited reward potential to the upside for the call calendar and limited, but high potential reward to the downside for the put calendar. Calendar spreads are purchased in a margin account, but no margin requirement is necessary because, theoretically, the purchased option has a longer life than the written option and should the short contract make an adverse move and be assigned, the investor can exercise the long contract, thus purchasing the underlying stock at the same price at which it was called away at and exit the strategy. Since the strike prices are the same, the total risk is limited to the initial debit paid when creating the calendar plus any commission costs.

To get a sense of the underlying stock's option value on you could use the option calculator found on the CBOE website at http://www.cboe.com/TradTool/IVolMain.aspx.

Let's look at a calendar spread example using Best Buy Co. Inc. which was trading at US$45.11 on September 8. The share price has been range bound for the past two months in the US$44 to $49 range giving you a US$46.50 average. If you have a slightly positive bias, since you are at the lower end of the trading range you could choose to sell the October 47.50 calls at US$1.50 and buy the March 47.50 calls at US$4.20 for a US$2.70 debit spread excluding commission costs. If the stock is below $47.50 in October then the near-term option would expire worthless.

The CBOE option calculator indicates that the short-term IV is 38.47 per cent with 43 days to expiry while the March contract has 190 days to expiry and has a 36.14 per cent IV. If the stock remains in the $45 range with the same IV through to the first expiry in October, then using a Black-Scholes calculator we could assume that the value of the March option with 147 days to expiry would be worth about $3.49. Thus you would automatically be in a net credit position of 79 cents or $79 per option as there are 100 shares associated with each option. We can further speculate, using the Black-Scholes calculator that at the October expiry, all things being equal, that the November options with 28 days to expiry at that point could be worth about 98 cents and December with 56 days to expiry could be worth about $1.68 and January at about $2.49 and so on, giving the investor additional possibilities to roll forward depending on their outlook.

Another popular use of the calendar spread is try to generate income similar to a covered call strategy, but involves buying LEAPS (Long Term Equity Anticipation Securities) instead of the actual stock. This strategy requires selling calls against the LEAPS instead of the actual stock. This is done because the LEAPS can be purchased much more cheaply than the actual stock, which can generate much higher returns on invested capital. The risk with this implementation is that the underlying stock goes down in price instead of staying neutral, causing your LEAPS to go down in value. If on the other hand the underlying stock goes up in price at expiration of the near term option (instead of staying neutral), you could buy back the option you sold and then sell another option, one or more months out."

As you can see there are a myriad of permutations and combinations to be had to structure a neutral portfolio using options. It just requires more research on the part of the investor.

Though the calendar strategy takes place over a longer period of time then a normal vacation, you are essentially in control of a low risk, stress-reducing strategy, which can be closed out at any time that you elect, it needs very little of your time and energy to maintain, and one that can earn you a handsome profit.

Yola Edwards is a contributing writer and technical analyst for Bell Globemedia Interactive, providing options and technical analysis research on a variety of North American equities.

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