- Posted by Richard Croft on May 10, 2010 filed in Options Market
Received a comment from Mr. Heng asking about last week’s discussion on the XIU calendar spread. In the blog, I suggested that the spread would be profitable if XIU remained in a trading range between $17.25 and $18.75 through to the May expiration. Mr. Heng asked how does one calculate that trading range?
The trading range is theoretical and looks at the underlying stock price as of the May expiration. At that point, the short option will trade at its intrinsic value (assuming the short option is in-the-money) or it will expire worthless. The only remaining question is what value would we place on the long July 18 call. To ascertain that value we would use the options calculator (http://www.m-x.ca/outils/calculateur/calc_legal_en.html) to provide us a theoretical value for the July 18 calls at the May expiration.
If the value of the July call at the May expiration is at least 30 cents (the initial debit for the calendar spread) more than the value of the short May 18 call, then the calendar spread would have broken even. Which effectively defines profitability given a price range for the underlying security.
I also mentioned that sharp moves up or down may negatively impact the position over shorter periods. The challenge, of course, is to evaluate what a sharp move would do to the position from two perspectives: an increase in volatility, which could enhance the position, and a sharp decline in the underlying stock price,which would negatively impact of the position because of the inherent stock price/strike price relationship.
Last week was an excellent case study, where those two factors effectively cancelled each other out. XIU closed down sharply on the week (Friday’s close was $17.27) and the calendar spread ended the week either flat or with a small 5 cents per share loss.
The second part of Mr. Heng’s question related to how one might follow up on the trade at the May expiration. Specifically, if the May options expire worthless, would we write the June 18 calls (the answer is yes!) and if so, how would we go about calculating a new profitable trading range.
The answer to the second part is to employ the same approach as we did establishing the trading range for the May-July calendar spread. Only this time your net debit will no longer be 30 cents, because you will have collected an additional premium from the sale of the June 18 calls. The additional premium effectively reduces the overall debit.
On the Home Run Front…
Nothing like hitting a home run or two! We did that on two fronts with perhaps a single based on the April 27th blog.
The first home run was the suggestion to buy the Teck (TSX, symbol TCK, Friday’s close $36.34) June 42 puts at $2.20. Last week these puts surged above $7.00 per share ($700 per contract). They closed Friday at $6.90. This is a triple on the original strategy, and whenever that happens, I always recommend that traders at a minimum, sell half their position. Take the cost off the table and ride the remainder.
The second home run was Canfor (TSX, symbol CFP, Friday’s close $9.56) where we looked at buying the CFP July 10 puts at 35 cents. Those puts got above $1.20 on the week and closed on Friday at $1.05. Same follow up, sell at least half your position and take your out-of-pocket cost off the table.
The single came about as part of the discussion around hedging your bets if you were a long term holder of Teck. The strategy was a covered call write (i.e., sell the Teck May 43 calls at $1.20) that while not fully hedging against the downside move in the stock, did dampen the loss. Certainly the covered call writer was in a better position than holders of Teck who did not write covered calls.