Got a question about options? Jay Kaeppel has over three decades of experi- cence in the options markets. He was a head trader for a CTA firm, an options trading software developer, and is a portfolio manager for an investment ‘management frm. He also spent several years writing a weekly colin titled “Kaeppel’s Corner” and now publishes a blog, “Jay On The Markets” (harp:// Jayonthemarkers.com). He is the author of several books, including ‘The Four Biggest Mistakes In Option Trading; The Option Trader's Guise To Probability, ‘Volatility, And Timing; and Seasonal Stock Market Trends. Send your ques- tions or topic suggestions to Jay Kaeppel at jaykaeppel@gmuil.com. Selected questions will appear in a future issue of S&C. HOW TO POSITION A TRADE USING A ‘CALENDAR SPREAD (PART 1) like the idea ofusing calendar spreads to take advantage of tme decay andior trading ranges. Unfortunately, it seems Tikeeverytime putone on, the underly. ing security makes a big move and Tend up with a loss. Any suggestions? ‘The keys to successfully utilizing any option strategy are: a) understand- ing “what makes it tick" b) putting as ‘many factors in your favor as possible the trade, and) a Tile bit of cooperation from the underlying security. If you put on a neutral trade and the underlying security “movesbig” ‘or if you put om directional trade and the underlying security “soes nowhere" ‘or in the wrong direction, typically. the ‘only relevant question is: “How do T mit my loss?” Ina nutshell, the only things you can ‘control ate Factors (and (b) mentioned earlier 0 it is your responsibility as a trader to make the effort to maximize those two each time out—with the rea istic understanding hat the wrong move by the underlying may still torpedo your best ideas. That is simply the nature of options trading. When wetalk abcutacalendarspread, the truthis there areany number of ways {o position a trade using this strategy. Asa result, this month's column will be part | onthis topic and next month's will The only way to achieve the maximum profit on a standard calendar spread is if the underlying security closes exactly at the strike price on the day of option expiration.at a faster rate than the longer-term optior ny Kacppol serve as part 2. To start let's first ay the groundwork by explaining the mechanies of the standard calendar spread. From there we can: a) talk about the factors thatinfiuence ths strategy.b) look athow ‘most traders use it, and finally, ) review some simple but sophisticated ways to ‘maximize the potential reward-to-risk tradeoff using a calendar spread. A standard” calendar spread involves buying a call (or put) option ina farther- ‘out expiration month and selling a call (o« put) option of the same strike price in a nearer expiration month, What makes the strategy work is simply that the option in the near expiration month will lose time premium at a faster rate than the longer-term option, solely as 2 function of time decay. So, in theory. if the underlying security simply remained unchanged in price,the shorter-term op- tion (which we are short) stands to Tose ‘moretime premium thanthe longer-term ‘option (which we are long),thus general- ing a net profit. Soc KSS— atocknewe Dividend | Gox6-06-12) {2g date |Poation| wom [Option Symbol| expire | Type | entry [eid/| tog aves vol o1foaye] pate [Carma] vaos Thats ik ero ST SER Srey 2010-07-20] sowohl ssaauoisc73 2018 02118 75, Nox Dri tax Risk Max Brt/ Cant '$20000| soar 0 | + '$10000 aa.zz|30 674 FIGURE 1: KSS NOV1-AUGS1 75 STRIKE PRICE CALL CALENDAR SPREAD. lit this rae has postive vga ad postive theta. Poli voga sugges asin ‘impli woatlty woul help this ade and a deci in ered vlatity would hurts ade Postive thet suggests ths trade wil make money duet time decay as ‘ach day passes ty, 44+ Decrter20 Tehaea Anahi of STOCKS & COMMODITIESOften, traders will trade near-the- ‘money optionsusing thecalendar spread strategy in hopes of making money if the underlying security remains within 4 particular price range. Figures 1 & 2 display @ “standard” near-the-money calendarspreadusing call optionsonthe ticker KSS. The trade buys the October 19 KSS 75 call and sells the August 31 KSS 75 put The maximum risk on a one-lot is S110 and the maximum profit potential $276. While this isa favorable reward- torTisk ratio there are several caveats. Remember, the only way to achieve the ‘maximum profit on a standard calendar spread is ifthe underlying security closes ‘exactly at the strike price on the day ‘of option expiration. So attempting to achieve the maximum profit potential should not be hi priority If volatility remains unchanged, this trade will generate a profit if KSS is between $67.73 and $84.42 per share 42 ‘days later whenthe August 31 put option ‘expires. IF KSS is outside of this range at expitation, this position will likely generate a loss, Here is the important thing tonote: the only way this trade can make money is: a) through the passage ‘of time, and b) KSS not moving beyond certain amount in either direction. As ‘you intimated in your question, if KSS ‘makes a big move in price this trade is ly destined to lose money. Of course, there is never any guarantee that the underlying will remain in a particular range, which is where the risk comes into play with a calendar spread. Once the underlying security moves too farin ‘one direction, it may be impossible fora given position to rezain profitability. ‘Notein the upper ightof Figure | that this trade has positive vega and post theta. Positive vegn tells us a rise in implied volatility would help this trade andadecline inimplied volatility would hhurt this trade. Positive theta ells us this trade willmakemorey duetotimedecay as each day passes. ‘Nowet'sconsiderthe primary factors to focus on when considering a standard near-the-money call or put calendar spread: 1, Support & resistance: In perfect world, we would like to seean obvi- ‘ous support & resistance price level ‘onapricechart While thereisnever any guarantee that some arbitrary price level willhold, price oftenhesi- tates before breaking out above an established resistance level orbelow 1 established support level. This hesitation—involving the passage of time—can make all the difference in giving a calendar spread enough time to become profitable. 2. Implied volatility: Hereis what you need to know. Longer-term options react more to volatility changes than shorter-te-m options do. So if you buy a longer-term option when implied volatility is high, you run FIGURE 2 NSS NOV1S-AUG31 75 STRIKE PRICE CALL CALENDAR SPREAD RISK GRAPH. iol ‘mains unchangod this tae wl generate a profit KSSis between $6773 and $442 ashare 2 days aor ‘hen the August 3 put option exes. December 208 Techical Ans of STOCKS && COMMODITIES therisk of losing money if volatility subsequently falls. As a result, one rule of thumb for calendar spreads is to focus your trades on stocks that are presently experiencing low implied volatility (IV). By entering calendar spread when IV is low you: a) improve your chances of avoiding a “volatility erush,” and b) create a scenatio where you might benefit if volatility increases after the trade i entered. 3. Barnings: Earnings announce- ments can at times have a profound effect on a stock’s price. Remem- ber that huge price movement is typically an enemy of the standard neutral calendar spread. If you are in ancutral calendar spread and an earnings announcement moves the stock significantly in either direc- fon, itcould work against you. This doesn’t mean you should never trade a calendar spread if an earnings announcement is forthcoming. But ‘you should be aware of this poten- tial risk, 4. Position management: Prior to centering astandard neutral calendar spread, there are a few questions ‘you should have already answered regarding position management ‘These inelude: “What will you do if price moves outside the range of profitability?” and “What would cause you fo take a profit?” (where the answer could be a certain per- centage profi a certain number of daysleftuntil expiration, andsoon), ‘One other contingency to plan for is the possibility of the short option to ‘rade in the money, in which case it could beexercised against you. This is not a catastrophic situation, as ‘you can simply exercise the option in which you hold a long position to offset this, But it is something you need to be prepared for. Look for some more information fon some unique ways t0 use the cal- cendar spread strategy in next months column, oho)