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Options Trading: How to Use a Put Calendar Spread to Trade Exxon Mobil

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When the combination of a bearish chart pattern and low implied volatility coincide, the knowledgeable options trader will often consider this trade structure.

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I have introduced some basic concepts of options in previous ruminations, discussed some of the considerations in finding an "options-friendly" broker, and made introductions to some of the family members we will come to know in our everyday trades. It is now time to begin to discuss the logic of choosing a trade structure as the trade vehicle.

Various traders approach this critical decision with a variety of paths. There is no right or wrong road to approach this decision, but it is essential that the decision be based on careful consideration of each of the three factors that rule the world of options: time to expiration, price of the underlying, and the status of the current position of implied volatility considered within its historic context for the specific underlying under consideration.

Let's consider a specific example that begins with consideration of the price chart of Exxon Mobil (XOM). As a result of my chart studies, I have concluded that it is likely that price will not exceed $86.75 and will likely pull back to lower levels.

For those of you who are familiar with multiple-legged Fibonacci patterns, the current situation is a bearish Gartley on the Exxon Mobil chart. I do not want to get sidetracked today on a discussion of Fibonacci patterns at this point, but we will return to their utility in future missives. For the more curious, a simple Internet search will lead to a wealth of explanatory information regarding these infrequently described patterns.

When considering the potential structures that could be used to trade this bearish pattern, I always consider first the position of implied volatility within its historic framework. The current situation is displayed below on the volatility graph for Exxon Mobil.



As can readily be seen, the current position of implied volatility is well within the lowest quartile of its recent historic range.

When the combination of a bearish chart pattern and low implied volatility coincide, the knowledgeable options trader will often consider immediately a specific trade structure -- the put calendar spread. Recall that this directional put spread is initiated by buying a longer dated put and selling a shorter dated put.

There are numerous minor variations of this spread, but in its classic form the short options are sold with around 30 days to expiration and the long options are purchased in the available next longer dated series. In the trade under discussion, we would sell the March series and buy the April series.

The potential profit engines in a calendar spread are two -- the more rapid time decay of the shorter dated option and the probability that the current low implied volatility of the option you own will increase as the stock declines in price.

Remember as a general rule that price direction of a stock is inversely related to changes in implied volatility. Another important point critical for understanding the trade is the realization that longer dated options are much more impacted by changes in implied volatility than are shorter dated options.

In our current bearish hypothesis for Exxon Mobil, we would then expect to see an increase in implied volatility of the options as price goes down, and we would expect that this increased implied volatility would more strongly impact the long put portion of our trade than it would the shorter-term short puts.

In this trade structure, maximum profitability always occurs at options expiration when the price of the underlying is at precisely the specific strike price in which the trade was constructed. Another comforting attribute of this trade construction is that it is relatively tolerant of changes in price, particularly if these changes evolve over a period of time and allow time decay of the short leg.

One important caveat when constructing this type of trade is that the trader must be aware of the differences in implied volatility between the different months selected for the trade. We do not want to be selling volatility at a level significantly lower than we are selling.

The P&L of these trades have a characteristic shape illustrated well in the example trade illustrated below:


Click to enlarge

I have chosen to construct this trade at the 85 strike, reflecting a modestly bearish price hypothesis. At current prices, this structure produces a profitable trade at expiration if the Exxon Mobil price lies between $83.33 and $87.62 at March option expiration.

Potential adjustments to accommodate price excursions beyond these ranges of profitability are beyond the scope of this posting. Suffice it to say that a number of potential adjustments can be implemented in a proactive manner to extend the range of price resulting in a successful trade.

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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