Option strategies: Calendar spread

I’m back from my blog world vacation. I wasn’t drinking margaritas on the beach but mostly filing taxes for a few people and working overtime on an iPhone application for a demo in Boston last week. The markets have been quiet lately and this means it’s time for a few calendar spread option plays.

The calendar spread can be done using calls or puts, depending on the implied volatility bias and which side you anticipate the market to go. Calendar spreads are best suited when used in a stable market or during a period of consolidation. Using them on ETFs is a good way to avoid exposure to a single company. The call calendar spread is established by buying a long term call with at least 3 months to expiration and selling a short term call with less than 45 days to expiration, at the same strike price:

• Long 1 call, at the money or slightly out of the money with more than 3 months to expiration
• Short 1 call, at the same strike with less than 45 days to expiration

This strategy works by capturing the time decay on the short term option while protecting the position with a long term option. Also, when the short term option expires, it’s possible to sell an other short them call against the long term call to keep the position running.

Risk

The maximum risk for this strategy is the amount paid for the initial position. The maximum profit varies with the volatility. The break even prices are also determined by the volatility.

Entry rules

• Implied volatility of the front month should be 15% higher than the IV of the bought call.
• There is a price consolidation in the underlying stock.
• Aim for a $2 debit per contract.

Exit rules

• Close the position during the expiration week of the sold option or let the short expire worthless then sell long call on the next business day.
• If you want to keep the position open, roll the short option forward during the expiration week if the long term purchased option still has over 2 months left to expiration.

Strategy graph

The performance graph for this position when bought:

Performance graph at expiration:

Volatility graph when bought:

Market update: Financials over-optimism?

For the past few weeks, the financial market has been getting most of the attention between the Obama speeches. The U.S. President is working hard to “fix” the system and make the world a better place:

President Obama vowed Sunday to pursue the elimination of nuclear weapons from the planet, telling a cheering throng in Prague that the United States is ready to lead an international effort to reduce atomic arsenals and the threat they pose.

This quote from an article at L.A. Times by Christi Parsons and Tom Hamburger is very pleasing to the ear and may help bring stability and boost the market on Monday. But this series of good, great and better news interleaved with a rally in the financial sector may soon take us back to reality. Analysts are digesting the new rules like the “mark-to-market” accounting method that is supposed to save the Financials but may as well be an other evil plan ready to explode. Looking at the XLF ETF, it looks like the Financials are ripe for a pull-back in the next weeks:

The next week is going to be an interesting one: I’ll be watching FAZ closely.

Option strategies: Long straddle

Back on the option trading strategies, today I’ll explain the long straddle. This strategy is initially Delta neutral, which means it doesn’t change a lot when the price stays the same. How is that profitable? When the underlying price changes a lot, either way, this strategy generates a profit. This position is also called a “long volatility trade”. This means it makes a profit when the underlying price volatility increases, even if the price doesn’t move, such as before a big event or earnings release.

The long straddle is formed using 1 call and 1 put at the same strike and same expiration:

• Long 1 call, at the money
• Long 1 put, at the money

Risk

The maximum risk for this strategy is the amount paid for the initial position. There are no margin requirements. The maximum profit you can get is unlimited on both sides. The upside breakeven price is the amount paid for the position plus the call strike price. The downside breakeven price is the put strike price minus the amount paid for the position.

Entry rules

• Implied volatility should be lower than the historical volatility.
• There is a price consolidation in the underlying stock.
• If expecting a big move after earnings announcement or event, make sure the volatility isn’t too high when opening the position because volatility will drops dramatically after the event.
• When buying before an event, try to enter the position 2 to 3 weeks before the release date, when option volatility is still low.
• Make sure the stock has a history of high price movement after earnings announcements.

Exit rules

• Close the position at least 20 trading days prior to expiration if there was no price movement.
• Close the position after the earnings announcement or event. If the stock has moved a lot since the position was opened, consider closing the position right before the announcement because the stock may go back to where is was.
• Close the position when a profit of 50% has been reached, considering opening cost of the position.

Strategy graph

The performance graph for this position when bought:

Performance graph at expiration:

Volatility graph when bought:

Direxion to offer monthly 3x leveraged ETFs

This is a follow up on my previous post about a trading strategy with FAS and FAZ, the Direxion Financial 300% ETFs. These two funds are tracking their index on a daily basis. This means a 10% drop today followed by a 10% rally tomorrow will NOT bring back the ETF to where it was. For example, if the fund started at $100, the 10% drop would bring it at $90. The next day, the 10% rally would bring it to $99, not $100 because 10% of $90 is only $9. In a volatile environment, this “eats” the fund’s value in a short time. But the value doesn’t really disappear… Direxion rebalances the funds everyday to make sure its value reflects the market, at 300% during the day.

To help longer term investors, Direxion will now offer similar funds with 2x and 3x leverage but tracking the index on a monthly basis. During the reference month, the value may drift away from the index value but should match the 200% or 300% return at the end of the month. In other words, this doesn’t replace the daily funds, it complements them. When more details are available about these new funds, I’ll see if I can find a strategy to trade the dailies with the monthlies.