In the last quarter of 2005, North American stock markets delivered a decent rally. And even though Canada’s performance was superior, in December U.S. stocks showed signs of life.
But while the Canadian market has continued its climb on the back of resources such as gold and oil, U.S. stocks have basically stalled, up one day and down the next. This leads one to think that we will probably see more grinding pain than upside gain this year.
If stocks remain within a tight trading range over the next month or so, writing naked calls and puts on individual stocks might be an effective strategy. In such a tight trading-range scenario, the options would be worthless upon their expiration, and the options writer would capture the premium.
The problem that the options writer faces is twofold, however. First, option premiums are low, which limits the amount an options writer would receive. Second, there is always the possibility that a stock will explode, either to the upside or the downside. This was demonstrated in January by the Intel Corp. sell-off, when earnings were weaker than expected.
The shock affect from a spike up or down is the “frazzled nerves” cost of trading naked options. A better approach to take in the options market is to look for strategies that can profit from a trading-range environment with limited risk.
The “calendar spread,” using either calls or puts, is a case in point. This strategy will allow you to trade with limited risk, profit from the certainty of time-value erosion and benefit from a spike in volatility.
A calendar spread — also called a “time spread” — involves the simultaneous purchase and sale of either calls or puts on the same underlying security at the same strike price, albeit with different expiration dates.
Encana Corp. is an interesting example. Its stock has been trading in a range between $50 and $60 a share for the past seven months — except for one burst through $65 a share. It went up to $68 a share this past October.
Assuming you think oil prices are range-bound, Encana could be an interesting candidate for a calendar spread. In this case, when the stock was trading at $55 a share in January, the Encana February 56 calls were trading at $1.90, while the Encana April 56 calls were at $4. A calendar spread would involve the purchase of the longer-term call — in this case, the April 56 call — while selling the shorter-term call (the February 56 call).
In terms of risk, the most you can lose with a calendar spread is the difference between the cost of the option you buy minus the receipts from the option you sold. In this case, without accounting for transaction costs, the net debit, or the spread, is $2.10 ($4 – $1.90 = $2.10).
As for the question of volatility, the Encana options were trading with an implied volatility of 39% at the time of writing. If the market accorded more risk to Encana, that might benefit the calendar spread.
For example, if Encana options were trading at an implied volatility of 50%, all other factors remaining the same, the Encana February 56 calls would be trading at $2.30 and the Encana April 56 calls would be trading at $4.50. The net difference expands from $2.10 when the position was established to $2.20 at the higher volatility assumption.
In an environment in which volatility remains the same, the calendar spread will benefit from time-value erosion. Suppose the stock remains near its current level until the nearer month’s option expires. The February 56 calls would worthless, but the April 56 calls would be worth $3.50, for a spread of $3.50.
On the return side, a calendar spread reaches its maximum profit potential when the stock is exactly at the strike price of the short near-term option. In a more general sense, at any point prior to expiration the spread will be at its maximum return point if the underlying stock is slightly above the strike price of the short call — if you are using calls to create the calendar spread.
If you are using puts to establish the calendar spread, you would want the underlying stock to trade slightly below the strike price prior to expiration.
@page_break@If you are trying to take a neutral stance, you would position the spread at a strike price at which you anticipate the underlying stock to trade, or slightly above it, in the two to three weeks preceding the expiration of the short near-term option.
In the Encana example, the spreader would like to see the stock trade slightly above $56 a share in the weeks leading up to the February expiration. IE
Calendar-spread strategy limits risk
Strategy also allows you to profit from the certainty of time-value erosion
- By: Richard Croft
- February 16, 2006 October 31, 2019
- 14:46