exactly how much value because of changes in implied volatility and time decay. To break even, the value of the long call when it is sold must be equal to the debit paid for the calendar spread. If the call is worth more, and the spread is closed when the short option expires, the trade yields a profit. However, it is impossible to calculate the exact value of the long call, and therefore, the breakeven when the short call expires. It is possi- ble to get an idea or rough guess, but it is better to use computer soft- ware to plot the risk graph and see where the potential breakeven points might be. Exiting the Position The exit strategy for the calendar spread is extremely important in de- termining the trade’s success. Specifically, if the shares remain range- bound and the short call expires worthless, the strategist must make a decision: (1) to exit the position, (2) to sell another call, or (3) to roll up to another strike price. Generally, if the shares are stable as anticipated, the best approach is to sell another shorter-term option. In our example, the long call has 18 months until expiration and was purchased for $4. A call with three months can be sold for $1. If, over the course of 18 months, calls with three months until expiration can be sold for $1 five times, the credit received from selling those calls totals $5. The cost of the long option is only $4. Therefore, the trade yields a $1 profit on a $4 investment, or 25 percent over the course of 15 months. Furthermore, after 15 months, the long call, which has been fully paid for, will still have three months of life remaining and can offer upside rewards in case XYZ marches higher. Sometimes, however, it is not possible to sell another call. Instead, the share price jumps too high and the risk profile associated with sell- ing another call is not attractive. In that case, the strategist might sim- ply want to close the position by selling the long call. Or another calendar spread can be established on the same shares by rolling up to a higher strike price. In that case, the strategist closes the long call, buys back another long call with a higher strike price, and then sells a shorter-term call with the same strike price. If the shares move against the strategist during the life of the short call, the best approach is prob- ably to exit the entire position once the short call has little time value remaining. If the shares jump higher and the long call has significant time value, it is better to close the position rather than face assignment or buy back the short option. If assigned and forced to exercise the long option to cover the assignment, the strategist will lose the time value still left in the long contract. Trading Techniques for Range-Bound Markets 283 ccc_fontanills_ch10_265-310.qxd 12/17/04 4:16 PM Page 283 Calendar Spread Case Study Shares of Johnson & Johnson (JNJ) are trading for $51.75 during the month of February and the strategist expects the shares to make a move higher. A bullish calendar spread is created by purchasing a JNJ January 2005 60 call for $4 and selling an April 2003 60 call for $1. The trade costs $300: (4 – 1) × 100 = $300. Therefore, the initial debit in the account is equal to $300. The debit is also the maximum risk associated with this trade. As the price of the shares rises, the trade makes money. As we can see from the risk graph in Figure 10.7, the maximum profit occurs when the shares reach $60 at April expiration and is equal to roughly $570. At that point, the short call expires worthless, but the long 284 THE OPTIONS COURSE Calendar Spread Strategy: Sell a short-term option and buy a long-term option using ATM options with as small a net debit as possible (all calls or all puts). Calls can be used for a more bullish bias and puts can be used for a more bearish bias. Market Opportunity: Look for a range-bound market that is expected to stay between the breakeven points for an extended period of time. Maximum Risk: Limited to the net debit paid. (Long premium – short pre- mium) × 100. Maximum Profit: Limited. Use software for accurate calculation. Breakeven: Use software for accurate calculation. Margin: Amount subject to broker’s discretion. Calendar Spread Case Study Market Opportunity: JNJ is expected to trade moderately higher. With shares near $51.75 in February, the strategist sells an April 60 call for $1 and buys a January 2005 60 call for $4. Maximum Risk: Limited to the net debit. In this case, $300: (4 – 1) × 100. Maximum Profit: Limited due to the fact that the short call is subject to assignment risk if shares rise above $60. Upside Breakeven: Use options software to calculate. In this case, roughly $47. Downside Breakeven: Use options software to calculate. In this case, same as upside breakeven. Margin: Theoretically, zero. The short call is covered by the long call. Check with your broker. ccc_fontanills_ch10_265-310.qxd 12/17/04 4:16 PM Page 284 call has appreciated in value and can be sold at a profit. If the strategist elects to hold the long call instead, another calendar spread can be estab- lished by selling a shorter-term call. At that point, the risk curve will prob- ably look different. The downside breakeven is 46.80. Below that, the trade begins to lose money. An options trading software program like Plat- inum can be used to compute the maximum gain and the breakevens. In this case study, the stock did indeed move in the desired direction. By April expiration, shares of JNJ fetched $55.35 a share. At that point, the short call would expire worthless and the strategist would keep the entire premium received for selling the April 60 call. Meanwhile, the January 60 call has not only retained all of its value, but it is currently offered for $5.10. Therefore, the strategist’s earnings are $210 of profit per spread ($1 received for the premium and $1.10 profit for the appreciation in the Janu- ary 60 call), for a five-month 70 percent gain. On the other hand, the strate- gist could also hold the long call and sell another short-term call with the same or higher strike price. If the strategist chooses to sell a call with a higher strike price, the position becomes a diagonal spread, which is also our next subject of discussion. VOLATILITY SKEWS REVISITED As we have seen, calendar spreads are trades that involve the purchase and sale of options on the same shares, with the same strike price, but dif- ferent expiration dates. One thing to look for when searching for calendar Trading Techniques for Range-Bound Markets 285 Profit –200 –100 0 100 200 300 400 500 40 50 60 Today: 63 days left Close= 51.75 42 days left 21 days left Expiration Stock Price 50 60 51.31 52.50 51.20 51.75 +0.44 11/13 12/05 12/27 01/21 Currently: 02-14-03 FIGURE 10.7 JNJ Calendar Spread (Source: Optionetics Platinum © 2004) ccc_fontanills_ch10_265-310.qxd 12/17/04 4:16 PM Page 285 spreads is a volatility skew. A volatility skew is created when one or more options have a seeable difference in implied volatility (IV). Implied volatility, as mentioned in Chapter 9, is a factor that contributes to an op- tion’s price. All else being equal, an option with high IV is more expensive than an option with low IV. In addition, two options on the same underly- ing asset can sometimes have dramatically different levels of volatility. When this happens, it is known as volatility skew. Looking at various quotes of options and looking at each option’s IV will reveal potential volatility skews. As previously mentioned, there are two types of volatility skews pre- sent in today’s markets: volatility price skews and volatility time skews. Volatility price skews exist when two options with the same expiration date have very different levels of implied volatility. For example, if XYZ is trading at $50, the XYZ March 55 call has an implied volatility of 80 per- cent and the XYZ March 60 call has implied volatility of only 40 percent. Sometimes this happens when there is strong demand for short-term at- the-money or near-the-money call (due to takeover rumors, an earnings report, management shake-up, etc.). In that case, the 55 calls have become much more expensive (higher IV) than the 60 calls. Calendar spreads can be used to take advantage of the other type of volatility skew: time skews. This type of skew exists when two options on the same underlying asset with the same strike prices have different levels of implied volatility. For example, in January, the XYZ April 60 call has im- plied volatility of 80 percent and the XYZ December 60 call has implied volatility of only 40 percent. In that case, the short-term option is more ex- pensive relative to the long-term call and the calendar spread becomes more appealing (although the premium will still be greater for the long call because there will be less time value in the short-term option). The idea is for the strategist to get more premiums for selling the option with the higher IV than he or she is paying for the option with the low IV. DIAGONAL SPREAD There are a significant number of different ways to structure diagonal spreads. Diagonal spreads include two options with different expiration dates and different strike prices. For example, buying a longer-term call option and selling a shorter-term call option with a higher strike price can be a way of betting on a rise in the price of the shares. The idea would be for the shares to rise and cause the long-term option to increase in value. The short-term call option, which is sold to offset the cost of the long-term option, will also increase in value. But if the shares stay below the short 286 THE OPTIONS COURSE ccc_fontanills_ch10_265-310.qxd 12/17/04 4:16 PM Page 286 strike price, the short option expires worthless. In this type of trade, the longer-term option should have some intrinsic or real value, but the option sold should have only about 30 days or so to expiration and consist of nothing but time value. This strategy profits if the shares make a gradual rise. Similar diagonal spreads can be structured with puts and generate profits if the shares fall. Diagonal Spread Example Diagonal spreads are a common way of taking advantage of volatility skews. Let’s consider an example to see how. The rumor mill is churning and there is talk that XYZ is going to be the subject of a hostile takeover. With shares trading at $50 a share, the rumor is that XYZ will be purchased for $60 a share. At this point, you have done a lot of research on XYZ and you believe that the rumor is bogus. Furthermore, you notice that the talk has created a time volatility skew between the short-term and the long- term options. In this case, the March 55 call has seen a jump in implied volatility to 100 percent and trades for $1.50. Meanwhile, the December contract has seen no change in IV and the December 50 call currently trades for $6.50. To take advantage of this skew, the strategist sets up a diagonal spread by purchasing the December 50 call and selling the March 55 call. The idea is for the short call to lose value due to time decay and a drop in implied volatility. Meanwhile, the long-term option will retain most of its value. The cost of the trade is $5 a contract or $500: (6.50 – 1.50) × 100. This is the maximum risk associated with the trade. There are no hard-and-fast rules for computing breakevens and maxi- mum profits for diagonal spreads. In our example, the ideal scenario would be for the short option to lose value much faster than the long option due to both falling IV and time decay. However, the term diagonal spread refers to any trade that combines different strike prices and different expiration dates. Therefore, the potential combinations are vast. However, it is possible to compute the breakevens, risks, and rewards for any trade using options trading software like the one available at Optionetics.com Platinum site. Exiting the Position The same principles that were discussed with respect to calendar spreads apply to diagonal spreads. If the shares move dramatically higher, the short option has a greater chance of assignment when it moves in-the-money and time decay diminishes to a quarter of a point or less. If the long call has sig- nificant time value, it is better to close the position than face assignment. If assigned and forced to exercise the long option, the strategist will lose the Trading Techniques for Range-Bound Markets 287 ccc_fontanills_ch10_265-310.qxd 12/17/04 4:16 PM Page 287 time value still left in the long contract. If the short option expires as antic- ipated, the strategist can close the position, roll up to a higher strike price, or simply hold on to the long call. In the previous example, a diagonal spread was designed to take ad- vantage of a volatility skew. Once the skew has disappeared and the ob- jective is achieved the strategist can exit the position by selling the long call and buying back the short call. However, it generally takes a relatively large volatility skew in order to profit from changes in implied volatility alone. Therefore, strategists generally use time decay to their advantage as well, which, as we saw earlier, impacts shorter-term options to a greater degree than longer-term options. In the example, the idea was to take in the expensive (high IV) premium of the short option and benefit from time decay. As a result, once the short option expires, there is no reason to keep the long option. Thus, selling an identical call can close the position. If the shares fall sharply, the trade will lose value and the strategist wants to begin thinking about mitigating losses. A sharp move higher could result in assignment on the short call as expira- tion approaches. Again, it is better to close the position than face assign- ment because the long option will still have considerable time value, which would be lost if the long call is exercised to cover the short call. Breakeven Conundrums While the risk to the diagonal spread is easy to compute because it is lim- ited to the net debit paid, and the reward is known in advance because it is unlimited after the short-term option expires, the breakeven point is a bit more difficult to calculate. Often, traders first look at the breakeven price when the short-term option expires. However, at that point in time, the longer-term option will probably still have value. In addition, the value of that long option will be difficult to predict ahead of time due to changes in implied volatility and the impact of time decay. For example, assume we set up a diagonal spread on XYZ when it is trading for $53 a share. We buy a long-term call option with a strike price of 60 for $3 and sell a shorter-term call with a strike price of 55 for $1. The net debit is $200. Now, let’s assume that at the first expiration the stock is trading for $54.75 and the short-term option expires worthless. How much is the longer-term option worth, and what is the breakeven? It is difficult to predict what the longer-term option will be worth because of the im- pact of time decay and changes in implied volatility. So, it is impossible to know the breakeven when the short-term option expires because it will also depend on the future value of the longer-term option. If the longer- term option has appreciated enough to cover the cost of the debit when the short-term option expires, the trade breaks even. 288 THE OPTIONS COURSE ccc_fontanills_ch10_265-310.qxd 12/17/04 4:16 PM Page 288 After the short-term option expires, the breakeven shifts to the expi- ration of the longer-term option. In this case, the breakeven price be- comes the debit plus the strike price, or $62 a share. However, the breakeven will change again if we take follow-up action like selling an- other short-term call option. In sum, it is difficult to know exactly what the breakeven stock price will be for the diagonal or calendar spread because we are dealing with options with different expiration dates. In these situations, the best ap- proach is to use options-trading software to get a general idea. However, even software is not perfect because it can’t predict future changes in an option’s future implied volatility. The best we can do is to calculate an ap- proximate breakeven and then plan our exit strategies accordingly. Diagonal Spread Case Study For the diagonal spread case study, let’s consider Johnson & Johnson (JNJ) trading for $51.75 a share in early February 2003. The strategist sets up a diagonal spread by purchasing a January 2005 50 call for $6.50 and selling the March 2003 55 call for $1.50. Again, there is time volatility skew when purchasing these contracts and the long call has lower IV compared to the short call. This type of time volatility skew is a favorable character- istic when setting up this type of diagonal spread. Trading Techniques for Range-Bound Markets 289 Diagonal Spread Strategy: Sell a short-term option and buy a long-term option with differ- ent strikes and as small a net debit as possible (use all calls or all puts). •A bullish diagonal spread employs a long call with a distant expira- tion and a lower strike price, along with a short call with a closer expi- ration date and higher strike price. •A bearish diagonal spread combines a long put with a distant expi- ration date and a higher strike price along with a short put with a closer expiration date and lower strike price. Market Opportunity: Look for a range-bound market exhibiting a time volatility skew that is expected to stay between the breakeven points for an extended period of time. Maximum Risk: Limited to the net debit paid. (Long premium – short pre- mium) × 100. Maximum Profit/Upside Breakeven/Downside Breakeven: Use options software for accurate calculation, such as the Platinum site at Optionetics.com. ccc_fontanills_ch10_265-310.qxd 12/17/04 4:16 PM Page 289 The risk, profit, and breakevens for this trade are relatively straight- forward. The cost of the trade is $500 and is equal to the premium of the long call minus the short call times 100: [(6.50 – 1.50) × 100]. The debit is also the maximum risk associated with this trade. Profits arise if the shares move higher. The maximum profit during the life of the short call equals $374.45. After the short call expires, the position is no longer a di- agonal spread. It is simply a long call. At that point, the strategist can sell, exercise, or hold the long call. The risk curve of the diagonal spread is plotted in Figure 10.8. It is simi- lar to the calendar spread. In both cases, the strategist wants the share price to move higher, but not rise above the strike price of the short call. A move lower will result in losses. If the stock rises and equals $55 a share at the March expiration, the short call will expire worthless. The strategist will keep the premium received from selling the short call and will have a profit from an increase in the value of the call. At that point, he or she can sell, ex- ercise, or hold the long call. If the trader elects to hold the long call, another diagonal spread can be established by selling another shorter-term call. So, what happened with our JNJ calendar spread? Shortly after the trade was initiated, shares rallied sharply and, in the week before expira- tion, the stock was well above the March 55 strike price. At that point, we would be forced into follow-up action because assignment was all but as- sured. For example, the week just before expiration, the stock was mak- ing its move above $55 a share. Seeing this, the strategist would probably 290 THE OPTIONS COURSE Profit –400 –300 –200 –100 0 100 200 300 40 50 60 Today: 35 days left Close= 51.75 23 days left 11 days left Expiration Stock Price 50 60 51.31 52.50 51.20 51.75 +0.44 11/13 12/05 12/27 01/21 Currently: 02–14–03 FIGURE 10.8 JNJ Diagonal Spread (Source: Optionetics Platinum © 2004) ccc_fontanills_ch10_265-310.qxd 12/17/04 4:16 PM Page 290 want to buy the short-term call to close because assignment would force him or her either to buy the stock in the market for more than $55 a share and sell it at the strike price or cover with the long call, which still has a significant amount of time value. So, facing the risk of assignment, the position is closed when the stock moves toward the strike price of the short call. The Friday before expiration, the January 2004 50 call was quoted for $8.50 bid. Therefore, the strategist would book a $2 profit on that side of the trade. At the same time, he or she would want to buy to close the short March 55 call, which was offered for $1. That side of the trade would yield a 50-cent profit. Therefore, taken together, the strategist makes $250 on a $500 investment. Time decay has indeed worked in this trade’s favor. The reason I like trading diagonal spreads is that they lend them- selves to numerous position adjustments during the trade process. For example, say we initiate a diagonal calendar spread on stock XYZ by pur- chasing a longer-term ITM call option and writing a shorter-term slightly OTM call option. This position can be put on at a lower cost than the tra- ditional covered call and with a subsequent lower risk. It also has a higher-percentage return than a covered call but still profits from time de- cay. However, the real advantage of the position in my view is its inherent flexibility. Consider just some of the adjustments afforded the options trader with the diagonal spread position: • XYZ is below the strike price that we initially sold: Let it expire worthless and realize the short-term call premium as a profit. We can then exit the long position, or sell another short-term call for the next month out. • XYZ is near or above the short strike price by the expiration date: Buy the short option back and sell back the long position to close the trade, or sell the next month calls of the same strike or even a higher strike if the underlying stock has an upward directional bias. • XYZ is deep in-the-money: Exit the entire position and rebracket the diagonal spread at the new trading range. In addition, we can convert from a diagonal spread to a horizontal if more than 60 days are still left until expiration. If we are going into the fi- nal 30 days of the long position we can transform this position into a verti- cal spread. Even though our XYZ example was created using calls, the trader can also construct this position using put options. These are just a handful of adjustments afforded the options trader when managing a diagonal spread. I encourage you to test and paper trade these types of positions. The adjustment possibilities are virtually endless and for my money that makes for a terrific options strategy. Trading Techniques for Range-Bound Markets 291 ccc_fontanills_ch10_265-310.qxd 12/17/04 4:16 PM Page 291 COLLAR SPREAD Collar spreads are usually one of the first combination option trades a per- son is exposed to after getting a grasp of what basic puts and calls are all about. They are usually presented as appreciating collars or protective collars. However, not much mention is given to the inherent flexibility of this position and how, as a trader, if you want to put just a little bit more effort into the trade, you can increase your returns. There are two types of collar trades: the protective collar and the ap- preciating collar. The protective collar is chosen when a person already owns the stock and has a bearish outlook but still wants to hold the stock. In this case, the trader would purchase an at-the-money put and at the same time sell an at-the-money call to finance that put. This essentially locks in the current price and protects the trade from losses until such time when the bearish scenario changes. The other type of collar is an appreciating collar. This is the one where you can make money and indeed trade dynamically if you desire. The appreciating collar involves buying stock and for every 100 shares of stock purchased buying an at-the-money put and selling an out-of-the- money call to finance the put. The key to this strategy is selecting a stock that has been in the news, whose volatility is high, and for which a type skew exists (a type skew is when a volatility skew exists between the put 292 THE OPTIONS COURSE Diagonal Spread Case Study Strategy: With JNJ trading for $51.75 in February, set up a bullish diago- nal spread by selling a March 55 call at $1.50 and buying a January 50 call at $6.50. Market Opportunity: Anticipate a short-term move higher in a trending stock. Look for time volatility skew to increase odds of success. Maximum Risk: Limited to the net debit. In this case, the risk is losing the premium paid for the long call ($650) minus the premium received for the short put ($150) for a maximum risk of $500. Maximum Profit: During the life of the short option, the profit is limited due to the possibility of assignment. In this case, above $55 a share, the strategist will be forced to engage in follow-up action. Upside Breakeven: No set formula. Will vary based on IV assumptions. Downside Breakeven: No set formula. Will vary based on IV assumptions. Margin: Amount subject to broker’s discretion. ccc_fontanills_ch10_265-310.qxd 12/17/04 4:16 PM Page 292 [...]... sold are often problematic Adjusting with Stock Adjusting a straddle with stock is a fairly easy to understand process and usually less difficult to execute If the straddle becomes too delta positive (long), shares of stock can be sold If the straddle becomes too short, stock can be purchased to easily adjust the delta The calculations of when to make an adjustment are much easier: When delta gets to. .. of shares (100)] Collar Case Study As we have seen, collars are combination stock and option strategies that have limited risk and limited reward With this strategy, the strategist buys (or owns) the shares, sells out-of -the- money calls, and buys out-of-themoney puts It is a covered call and a protective put (which involves the purchase of shares and the purchase of puts) wrapped into one The idea is... therefore zero because the shares are already held in the portfolio and the cost of the put is offset by the sale of the call The risk to this trade is to the downside, but is limited to the strike price of the put The maximum risk is equal to the initial stock price minus the strike price of the put plus the net debit (or minus the net credit) In this case, the maximum risk equals $500: [(50 – 45)... higher, the stock will probably be called (due to assignment) when the time premium has fallen to a quarter of a point or less Therefore, if the price of the stock has risen above the strike price of the short call and the strategist does not want to lose the shares, it is better to close the short call by buying it back If not, the call will be assigned and the trader will make the profit equal to the. .. due to the remaining time value), the position could be closed at a profit The August 45 put is sold at a loss for the bid price of 60 cents a share The August 55 call is bought back (buy to close) for the offering price of $3 and AIG is closed for $ 56 As a result, the call is a wash The put results in a $270 loss and the stock is sold at $5.82 a share for a $582 profit The total profit on the trade is... Watch the market closely as it fluctuates The profit and loss on this strategy is limited Choose an exit strategy based on price movement of the underlying stock and the effects of changes in implied volatility on option prices • The underlying stock falls below the put strike price: Do nothing The shares are covered by the long put If you exercise the put and sell the stock, also sell the call to close... stock that has had a spike in its options’ IV, but IV should fall sharply as the stock consolidates Another way to find candidates for this strategy is to get a list of highIV stocks and look at their charts The easiest chart pattern to see is a stock in a trading range By eyeballing dozens of stocks that have high-IV options, we can often find great candidates to use for a butterfly strategy When looking... Nonetheless, a butterfly spread is an excellent strategy for making a profit in a sideways-trading market, but make 310 THE OPTIONS COURSE sure you understand the risks and are willing to accept the possible consequences if the stock does not stay within your channel This chapter also took a good look at calendar and diagonal spreads These versatile spreads can be constructed using calls or puts I usually... the difference between the exercise price and the original purchase price of the stock minus any debits (or plus any credits) The put, on the other hand, will protect the stock if it falls If the stock drops sharply, the strategist will want to buy back the long call and then exercise the put If the short call is not closed and the put is exercised, the strategist will be naked a short call Although it... the price of the stock declines, you may lose your profits, and perhaps some of the original premium due to time decay 3 Adjust the position There are several ways to do this The idea is to continue in the trade while simultaneously capturing profits and returning the overall position delta to zero These three alternatives possess their own respective advantages and disadvantages Often the best choice . rise in the price of the shares. The idea would be for the shares to rise and cause the long-term option to increase in value. The short-term call option, which is sold to offset the cost of the. continue to hold and eventually let the calls and puts expire worthless, and then sell the stock to take your profits. If it is above the strike price, the calls you sold will carry away the stock and the. it falls. If the stock drops sharply, the strategist will want to buy back the long call and then exercise the put. If the short call is not closed and the put is exercised, the strategist will