A Decently Written Article That May Help With Deciding Which Option Strategy To Use
Choosing the Right Options Spread Strategy
By Steven Smith
Senior Columnist
5/26/2006 9:01 AM EDT
On Tuesday in TheStreet.com Options Alerts newsletter, I added a calendar spread on Lehman Brothers (LEH:NYSE - commentary - research - Cramer's Take),
where investors might buy a June/July $70 call spread for a net debit on a stock in which, I wrote at the time, the implied volatility of its front-month options has climbed to 32%, the highest level of the year, while the IV of later-dated options is in the 27% area.
A reader rightfully questioned my rationale, noting: "I have been taught that calendars work better with low IV. The IV is high on Lehman, creating the skew. Can't we be hurt by an IV crush on this?" He also wondered what the exit strategy was for such a position.
Before breaking down my thought process -- no need to rush into that thorny task -- and discussing how the choice of out-of-the-money strike prices gives this traditionally neutral strategy a directional bias, let's quickly review the basic construction and characteristics of calendar spreads.
Getting Time on Your Side
A basic long calendar spread consists of selling options, either calls or puts, never both, of a nearby expiration, while simultaneously buying options with the same strike price but a more distant expiration. (Want an options primer? Check out my glossary and other options stories here.
For example, being long the June/July 70 call calendar spread means you are short the June 70 call and long the July 70 call. The position is done for a net debit, and that cost represents the maximum risk. Going short a calendar spread involves buying the front month and selling the later-dated option for a net credit, but that's a strategy for another time (pun intended).
The rationale behind a long calendar is that the position will benefit from time decay because the time value of the short front-month call will erode faster than the back-month call, creating a positive theta. (Remember that theta is defined on slope and accelerates as expiration approaches.)
The at-the-money (ATM) options, which have the highest price without containing any intrinsic value, offer the richest premiums, making them the most attractive candidates for harvesting time decay. But as the strikes move in or out of the money, the calendar spread contracts or losses value, therefore, these are best when you expect flat markets. As a net-debit position, a long calendar spread also benefits from an increase in implied volatility, and conversely, is negatively impacted by a decline in IV; this is referred to as the vega risk.
Stepping Into the Briar Patch
With the above in mind, it's understandable why many people feel the optimal application of a calendar spread would be to use at-the-money options on a stock with a narrow trading range and a low IV. In theory, you just put on some at-the-money calendar spreads, wait four weeks and earn an easy 3%-5% for the month.
It is also accurate that if one wants to establish a position that is strictly a theta, or time-decay, play, using ATM options that have a low IV, which minimizes vega risk, would be the optimal way to benefit from flat stock. But this approach has its downsides, namely that not many stocks remain flat for extended periods, and any price move, up or down, will have a negative effect on the ATM spread's value.
Given that the current environment has generated some of the most volatile trading in over two years, the probability of a stock's price remaining within a 1% to 2% range for a four-week period is even lower than usual. Also, delta-neutral positions, which is how most ATM calendars start off, tend be exactly that: they deliver neutral returns. Even in the best-case scenario -- the shares of the underlying being at the strike on the front or short month's expiration -- the risk/reward is typically no better than 1 toi 1.
That is why, in cases such as the trade in question, I use out-of the-money (OTM) strikes to create a low-cost position with a directional bias. Unlike the neutral ATM spread, which only profits from the time decay that results from a flat or unchanged stock price, an OTM spread offers three ways to profit; a directional move in which the stock moves toward my strike price, an increase in volatility, and time decay.
Now let's address the issue of vega risk, or why would I, in the same breath that I note that IV has climbed to a 52-week high, suggest establishing a long calendar spread? Again, it comes back to how using an OTM spread aligns with my market expectations.
Namely, I believe that the IV on Lehman will remain relatively high over the near-term. And although a rise in share price will likely be accompanied by a decline in IV, the benefit from the increase in the share price will outweigh the decline in IV. And remember, the option chain was showing a skew, with the June options carrying an IV of 32%, while July's IV was around 28%, meaning the position will also benefit from a flattening of the skew that would occur as part of an overall IV decline.
If the shares decline, the stock's IV will likely climb, though not enough to completely offset the decline in the spread's value. Since the position was established on Tuesday, shares of Lehman have declined to a low of $63.50, and IV has climbed to 36%. The value of the $70 calendar spread has declined a dime to 70 cents, while the value of the $65 ATM has declined by 30 cents to $1.
Although both positions suffer losses if the stock declines, the $65 at-the-money position will realize a loss on anything greater than a 5%, or $4.00, price increase, but the $70 out-of the money strike will profit up to a 14%, or $9.00, price increase.
Also note that even in the best-case scenario, in which the underlying is at the strike price at expiration, the returns in both dollar and percentage terms is superior when using an OTM strike. The bottom line is that even if IV declines, the directional bias of the OTM calendar spread offers not only a better risk/reward, but also a higher probability of profitability than a non-directional ATM calendar spread.
