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Options Trading: An In-Depth Analysis of Calendar Spreads

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For those used to trading stocks, instant gratification can be the reward for a correctly entered trade. That is not always the case with options trades.

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Last week's missive began the introduction of the three major families of option trade constructions (see Learning the Various Trade Constructions Available for Options Trading). My purpose in this approach is to make the reader familiar with the concept that certain groups of trades share common characteristics.

The reason for this approach is to try to render the selection of the specific trades the new option trader must consider in his quest to fit his price and time scenario to the multitude of option trades available for consideration. To proceed without understanding the similar characteristics of family members renders trade selection unnecessarily cumbersome and unwieldy.

Our first family introduction was that of the vertical spread family. The four individual members of this family are call debit spread, call credit spread, put debit spread, and put credit spread. The similar trade constructions share many of the same characteristics.

We saw the family portrait with its characteristic features of having a single breakeven point and reaching maximum profitability only when deep in-the-money or at expiration.

A complicating factor in learning to understand options is that each of the various trades usually has several names. This complication applies across all families of trades and results in a confusing variance of terminology that can slow down the learning process. Such is life when operating in the world of options.

There remain for introduction two major families. Of course there is the occasional renegade construction that no family wants to claim, but we will consider these potentially useful loners on a case-by-case basis as the needs arise.

The two families we will discuss next are those of the horizontal spread and the interesting category of the "winged" constructions. This latter category includes several colorfully named characters such as butterflies and condors.

For today, let us consider the group of horizontal spreads. These trades are also often called time or calendar spreads and are constructed by selling a shorter dated option and buying a longer dated option at the same strike price.

The profit engine in these trades is that of the differential decay of the time premium component of the option premium. Time premium, or the extrinsic component of the total premium, decays the fastest in options with the least time to expiration. In addition, it is important to understand that this decay of time premium is nonlinear and accelerates as expiration approaches.

The family portrait of such a trade constructed in ExxonMobil (XOM) using calls is displayed below:


Click to enlarge

This ExxonMobil calendar spread is a defined risk trade, which always reaches maximum profitability at expiration when the price of the underlying is at the strike price selected to construct the trade. It is therefore easily crafted to reflect the trader's price scenario for the underlying.

A warning to new traders is in order here. For those used to trading stocks, instant gratification can be the reward for a correctly entered trade. That is not always the case with options trades. In the case of horizontal spreads under discussion today, time must pass for the full profit potential to be realized. Significant time decay of the short leg is necessary to deliver strong profits.

The risks in this trade are two:
  1. Price of the underlying
  2. Implied volatility
The first risk is relatively straightforward and plays out should price escape the upper or lower break even points at expiration. This risk is usually easily mitigated by adding additional horizontal spreads to widen the zone of profitability. From this maneuver is born the slightly more advanced groups of double and even triple calendar spreads.

The second major risk is a decrease in the implied volatility of the option the trader holds long. Because longer dated options are more sensitive to changes in implied volatility, the position can be negatively impacted by decreases in this variable. This risk factor is less easily accommodated than that of price.

Knowledgeable option traders generally enter these type trades only when implied volatility of the long leg is within the lower third of its historic range.

The range of implied volatility for a given underlying usually has a characteristic range and exhibits a strong tendency to revert to its mean. Buying volatility in the lower portion of the range puts the wind at the traders back and increases the probability of a successful trade.

I look forward to next week when I will introduce the group of winged trade constructions!

Editor's Note: JW Jones offers more content at OptionsTradingSignals.com.

For more on options trading, take a 14 day FREE trial to OptionSmith. Get access to veteran options trader Steve Smith's portfolio along with emailed alerts and strategy with every trade he makes. Learn more.
No positions in stocks mentioned.
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