Dan Passarelli MarketTaker.com
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Trading is all about exploiting opportunities as they come. And option trading is chock full of opportunities because of the multiple price influences that can each be exploited. One of the opportunities option traders can take advantage of is time and its effect on option prices.

Time Decay
All options have a limited life. As the useful life of an option decreases, so does its value—all other factors held constant. This phenomenon is known as time decay. Trading calendar spreads offers a way to capitalize on time decay while providing limited risk.

Trading Calendar Spreads
A calendar spread involves buying one call option (or put option) and selling another call (or put) on the same underlying, with the same strike price but with a shorter term to expiration. Here’s an example.

Imagine a stock is trading at $50. You believe this stock will trade in a narrow range for the next 30 days. This could be a good candidate for a calendar spread. In this example, the June 50-strike calls (which expire in one month) are trading at 2.30 and the August 50-strike calls (expiring in three months) are trading at 4.10. We can construct a calendar spread by buying the August option and selling the Junes. Here we are “buying the calendar” for a 1.80 debit (4.10 – 2.30). (*Please note, this example does not include commissions).

OK, so how do calendar spreads benefit from time decay? At-the-money options decay at a “non-linear rate”, meaning options with less time to expiration lose their value at a faster rate, often a much faster rate, than comparable longer-term options. A trader can capitalize on the rapid rate of time decay, or theta, by selling the short-term option while hedging directional risk by purchasing the long-term option.

What happens if the position is held until expiration?
It is interesting to look at what happens both below and above the strike at expiration of the one-month call. If the underlying stock is below the strike price at June expiration, the June call expires. You are left with a long position in a 50-strike call that now has two months to expiration—a bullish position. This call has an effective purchase price of 1.80 (the 4.10 originally paid for the long call minus the 2.30 of premium received on the sale of the short call).

With the stock above the 50-strike at expiration, the short call will be assigned, which will create a short position in the underlying stock, and you are still left with the long 50-strike August call with two months to expiration. This is a synthetic long put—a bearish position.

The best-case scenario is that the stock is trading right at 50 at expiration of the June call. Here, the June call expires, profiting the entire 2.30 premium collected upon its sale. The August call would lose less; say only about .80 to time decay. In this case, the position has a maximum net profit of about 1.50, all else held constant. From a directional perspective, this is the maximum value the remaining call can have without the short call being assigned and incurring potential losses associated with the assignment above the strike.

If your forecast on the stock is slightly bullish, you can construct a calendar spread using out-of-the-money calls. This allows for the long call to profit from an upward movement in the underlying without the short call being assigned. The key is that the stock moves up to, but not through the strike price. When deciding on which strike to purchase a calendar spread, it is best to select the strike at which you believe the stock will be at expiration or upon exiting the position.

At June Expiration
At some point in time, whether it is on expiration day or before, the June call will have little or no time value left. Ideally, the stock is trading very near the strike. At this point, you can exit out of the entire position and take a profit (or loss) and move on to the next trade.

If, however, your forecast on the stock at this point in time continues to be neutral, you may want to roll out of your expiring call and sell another one-month call against the August call. If the short call has very little time left to expiration, the stock is still trading around $50 and volatility is unchanged, the one-month call you are rolling into should be trading fairly close to 2.30. If, after the passage of the next month, your forecast is, again, correct and the stock is trading at $50, you keep another premium of 2.30 and you are left with a long call position. You have now collected two premiums totaling 4.60, and you are left with a long position in a one-month call that you originally purchased for 4.10.

This is a critical point. You can trade out of the entire position, taking your profit (loss), and move on to the next trade. You can roll further out in time on both the short and the long call, establishing a new calendar spread on this stock. Or, if you are bullish, you can simply do nothing, allowing the short call to expire and hold the August call already owned. In this particular example, in which the stock remains flat for two months, there is no risk in owning this one-month call. The worst-case scenario is that at expiration the August call is out-of-the-money and expires worthless. You still profit, overall, .50 (the total of 4.60 collected in premium on the two calls that have been sold over the last two months less the 4.10 originally paid for the long call).

It is important to note that the premium paid for the long call is not always “paid for” after collecting just two months of premium. Often times it will take several months of collecting time decay from selling options to finance the long option leg of the spread. Many traders will construct a calendar by selling the one-month option and buying an option with a much longer term to expiration, or even LEAPS® options. This way, if your forecast remains the same, you can continue selling one-month options against the same long position. If your forecast changes, you have the option of trading out of the entire position or holding the long, which at some point, will be owned “for free”. Furthermore, if the stock makes a big move in either direction, the trade can end up a loser instead of giving you the “free call”.

Wrap Up
Understanding calendar spreads creates a whole new set of opportunities for traders. It also helps traders understand options on a deeper level, helping them to trade other strategies with more knowledge and confidence.

For questions or to learn about mentoring with Dan Passarelli, contact him at dan@markettaker.com or visit his company website: http://www.MarketTaker.com.

Dan Passarelli is the author of the book Trading Option Greeks and the president of Market Taker Mentoring LLC. Market Taker Mentoring provides personalized one-on-one mentoring for option traders. The company website is http://www.markettaker.com.

Dan started his trading career on the floor of the Chicago Board Options Exchange (CBOE) as an equity options market maker. He also traded agricultural options and futures on the floor of the Chicago Board of Trade (CBOT). In 2005, Dan joined CBOE’s Options Institute and began teaching both basic and advanced trading concepts to retail traders, brokers, institutional traders, financial planners and advisors, money managers, employees of the SEC and Federal Reserve Bank, and market makers. In addition to his work with the CBOE, he taught options strategies at the Options Industry Council (OIC). Dan has been featured on television and radio and has written numerous articles in the financial press. Dan can be reached at dan@markettaker.com. He can be followed on Twitter.

Q&A

Name: Kenneth
Subject: Trailing Stop Trigger
Q: Which type of trailing stop do you recommend using: points or percentage? For example, does 0.2 points = 20 cents? I just did a September call option using 10% at $21 and the stock is currently trading around $19. Did I select the best type of trailing stop?

A: Great question. Stop losses can be a tremendous aide to a trader but it's not always clear how best to use a stop loss. Certainly stop losses are more of an art than a science.

First, traders need to consider that stocks and options trade in points and ticks so the ultimate decision of where to place the stop loss will be based on good old dollars and cents. That being said, traders need to look back on the volatility of the security, and therefore, use expected percentage moves in the stop-loss decision-making process. For example, using a 0.25 stop loss may make sense on a $10 stock or an option, but not for a $400 stock.

Stop losses can be tricky with options--especially spreads. Because of the leveraged nature of options, the bid-ask spread can represent a much higher percentage of the asset's price than it would for an underlying stock. That means, where selecting a roughly 10 percent stop loss in a stock may be appropriate in certain situations, a 10 percent stop loss in an option is often not the smartest play. Traders need to consider the fact that options are leveraged instruments and accept bigger percentage stop losses as part of the game. Furthermore, option spreads, with two or more options, have more than one bid-ask spread to contend with. It is often hard to implement a stop loss that makes sense on multi-legged strategies. In many cases, manually monitoring the spread and using creative adjusting is the only practical means for managing spread risk.