Running the “October gauntlet”

The intrinsic value for a call option is calculated as the difference between the underlying security’s current price minus the strike price of the call. For a put option, intrinsic value is the difference between the strike price of the put minus the underlying stock’s current market price.

Look at the time value

“Time value” is what an options trader is willing to pay to create a leveraged position with limited risk. Time erodes as the option nears expiry and reaches zero upon expiration. Complicating any discussion about options pricing is the fact that time does not erode in a straight line. In fact, time decay follows an exponential trajectory, picking up speed as an option nears expiry.

To explain an exponential trajectory, think about it these terms: an option with nine months to expiry would be expected to have approximately twice the time value of a three-month contract, with three being the square root of nine. Similarly, a four-month contract would have about half the time value of a 16-month option, as four is the square root of 16.

The calendar spread involves the simultaneous purchase of a longer-term call (or put) while short-selling a shorter-term call (put) at the same strike price. The objective is to take advantage of this time decay’s trajectory: the shorter-term option will lose value at a more rapid pace than the longer-term option.

Because the longer-term option covers the short position, the risk in the calendar spread is limited to the difference in the cost of the two options.

For example, at the time of writing, Suncor Energy Inc.’s stock was trading at $37.30. The Suncor January 38 calls were trading at $1.30 and the Suncor November 38 calls were valued at 75¢.

You could set up a calendar spread by purchasing the Suncor January 38 calls and selling the Suncor November 38 calls for a net debit of 55¢. That debit is the maximum risk in the position. The maximum initial profit on this spread would occur if Suncor closed at exactly $38 on the November expiration.

An attractive approach

In that scenario, the November 38 call would expire worthless but the “at the money” January 38 call (with two months to expiry) would probably be worth at least $1.10 a share. Assuming you still liked the prospects for Suncor, you could hold the January 38 call and take advantage of further gains in the underlying stock.

Obviously, it’s highly unlikely that Suncor would close at exactly $38 on the November expiration. However, there is better than a 50/50 chance that Suncor will close at some price below $38 at the November expiration.

The calendar spread is always a reasonable strategy, given the certainty of time-value erosion. However, this year, there are factors that make the calendar spread unusually attractive: Think about the equities market’s smooth ride through September, which historically has been the most difficult month statistically for stocks.

October, on the other hand, is notorious for “black swan” events. And, this year, there are many such black swans on the horizon – a U.S. government shutdown being front and centre; followed, most likely, by a rancid debt-ceiling debate and the possibility of another surprise by the U.S. Federal Reserve Board. This list does not even mention the third-quarter earnings parade, which, by most accounts, will disappoint.

The calendar spread may well provide a path for traders to run the so-called “October gauntlet.” And since the market will most likely survive, your clients could end up with a low-cost leveraged play on stocks they want to own while defending those positions against potential volatility during October and November.

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