Calendar spreads offer an interesting way to play fourth-quarter earnings, which will heat up in February as earnings are announced. In fact, things will look even more attractive in February should the U.S. come to a resolution regarding its “fiscal cliff,” which would keep volatility low.
The calendar spread involves the purchase of a longer-term option – either calls or puts – together with the sale of a shorter-term option; both options must have the same strike price.
For example, a calendar spread on XYZ trading at $100 a share – assuming 25% implied volatility – might involve the sale of February 100 calls at $3.10 combined with the purchase of XYZ May 100 calls trading at $6.10. Because the longer-dated option covers the near-term short option, no margin coverage is required.
The out-of-pocket cost for this trade is the difference between the cost of the long (May) option and the premium received from the short (February) option: $3 a share in this example. The net debit is also the maximum loss that could result from the position.
The appeal of this trade is in the certainty of time value erosion. The closer an option gets to expiration, the faster its time value erodes. The value of the February options will erode at a much faster rate than will the May options – almost twice as fast, assuming the underlying stock remains in a relatively narrow trading range. It’s certain that the time component of the options price will decline to zero at expiration.
At any stock price below $100, the XYZ February 100 calls will expire worthless; and if XYZ is relatively close to $100 a share, the spread will almost certainly be profitable. In fact, at any price between $95 and $106, the spread should be profitable at the February expiration.
The best-case scenario would see XYZ close at exactly $100 a share upon the February expiration. In that scenario, the February 100 calls would expire worthless and the May 100 calls would be worth approximately $5.15.
Time value erosion is not the only thing that makes this strategy interesting. The calendar spread benefits from a spike in volatility because volatility has a bigger dollar-value impact on the longer-term option. The prices used in the XYZ example assumed 25% implied volatility. But if we assumed 40% implied volatility at the point the spread position was established, the calendar spread would cost $4.60 to implement rather than $3.
There are risks, of course. If the underlying stock’s share price should rise or drop substantially, the calendar spread will lose money. During periods in which there are violent swings in the stock’s price, time will take a back seat to the relationship between the strike price and the underlying stock price.
Another dimension that makes this strategy interesting during earnings season is that traders will pay more for shorter-term options prior to an earnings release. Traders pay a higher premium for the shorter-dated options based on the range of potential outcomes at the point earnings are released. The longer-dated options typically trade at an implied volatility that is more closely aligned with the longer-term prospects for the stock. In this scenario, clients executing calendar spreads are selling higher volatility and buying lower volatility.
In a worst-case scenario, your client is not likely to lose the entire net debit. As long as the May options have time remaining, they will retain some value. Even in a scenario in which the underlying stock’s price dropped substantially, volatility would probably spike, which would benefit the longer-term call.
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