- Posted by Richard Croft on December 10, 2012 filed in Options Market
Calendar spreads offer an interesting way to play fourth quarter earnings that will heat up in February. It will look even more attractive in February should the US come to some resolution on the fiscal cliff that keeps volatility low.
The calendar spread involves the purchase of a longer term option - either calls or puts – together with the sale of a shorter term option both having the same strike price.
For example a calendar spread on XYZ trading at $100 per share – assuming 25% implied volatility - might involve the sale February 100 calls at $3.10 combined with the purchase of XYZ May 100 calls trading at $6.10. Because the longer dated option covers the near-term short option no margin is required.
The out-of-pocket cost for this trade is the difference between the cost of the long option and the premium received from the short option ($3.00 per share in this example). The net debit is also the maximum loss that could result from the position.
The appeal with this trade is the certainly of time value erosion. The closer the option gets to expiration the faster time value erodes. The value of the February options (which we will assume expires in 5 weeks) will erode at a much faster rate than will the May options (expiring in 18 weeks). Almost twice as fast, assuming the underlying stock remains in a relatively narrow trading range. The certainty is that the time component within the options price will decline to zero at expiration.
At any stock price below $100 the XYZ February 100 calls will expire worthless and if XYZ is relatively close to $100 per share the spread will almost certainly be profitable. In fact at any price between $95 and $106 the spread should be profitable at the February expiration.
The best case scenario would see XYZ close at exactly $100 per share at the February expiration. In that scenario the February 100 calls would expire worthless and the May 100 calls would be worth approximately $5.15.
Time value erosion is not the only thing that makes of this trade interesting. The calendar spread benefits from a spike in volatility because volatility has a bigger dollar value impact on the longer term option.
The prices used in the XYZ example assumed a 25% implied volatility. But if we applied a 40% implied volatility assumption at the point the position was established the calendar spread would have cost $4.60 to implement rather than $3.00.
There are risks of course. If the underlying stock should rise or fall substantially, the calendar spread will lose money. During periods where there is violent swings in the stocks’ price time will take a back seat to the relationship between the strike price and the underlying stock price.
There is another dimension that makes this interesting during earnings season is that trader will pay up for shorter term options prior to an earnings release. Traders pay a higher premium for the shorter dated options based on the range of potential outcomes at the point earnings are released. The longer dated options typically trade at an implied volatility that is more closely aligned with the longer term prospects for the stock. In that scenario investors calendar spreads are selling higher volatility and buying lower volatility.
In a worst case scenario you would not likely lose the entire net debit. As long as the May options had time remaining they will retain some value. Even in a scenario where the underlying stock dropped substantially volatility would probably spike which would benefit the longer term call.