Options Sage submits:
“Minimize Risk, Maximize Reward”
The statement is so simple yet it can be easily violated when trading options. In fact, so many permutations and combinations exist when trading options that it’s often easy to forget the principles by which every trade should be entered. The phrase “Minimize Risk, Maximize Reward” is one of those golden phrases that you should have written on a post-it near your screen. All the really good options traders I know consistently abide by it and I thought it might be worth sharing some insights following an interesting discussion with Phil last week.
Our discussion was centered on calendar trades and their relative benefits. For those of you not entirely familiar with the basics of calendar trades, here’s a brief overview before we get into the nitty-gritty!
Call Calendar Basics
A Calendar trade simply means options are placed in different expiration months. The most widely used calendar trade is a call calendar, which usually involves:
Buying to Open a Long Call (2-6 months of time value) & Selling To Open a Short Call (< 30 days of time value) at the exact same strike price.
For example, let’s say you were a big fan of Apple and you concluded from your fundamental and technical research that Apple was overbought in the short-term and likely to consolidate, pullback or only rise slightly yet longer term you believed there was still greater room for the stock to move, then you could consider the following trade.
July Long Call Strike $110, $6.20 Debit
May Short Call Strike $110, $1.00 Credit
The July Long Call summarizes your expectations as being longer term bullish while the shorter-term May short call indicates that you are expecting a stagnant/bearish trend in the near future.
Risk = $6.20 – $1.00 = $5.20
Return on Risk = $1.00 / $5.20 = 19% (in 5 trading days!)
The attraction to these trades is obvious when you look at the rate of return, 19% return on risk in 5 trading days is outstanding. In practice, once the short call expires worthless, the long call can be sold and due to bid-ask spread the return might decrease somewhat. However, the rate of return would still be phenomenal and in fact, if the stock rose slightly (but did not go beyond the short call strike by much) then the long call could profit too which would cause the return to be even higher than 19%!
Looking at the options instruments, the call calendar essentially means that you are buying the right to buy stock at a certain price while selling to someone else the right for them to buy stock at the exact same price. It seems somewhat ridiculous to put yourself in a position where you may be forced to sell stock upon assignment at a certain price and must exercise your long call to offset that assignment. In so doing the net result of the stock transaction is zero (i.e. buying and selling stock at the same price) but the options transactions would be costing you money (assignment of the short call credits your account while exercise of the long option debits your account – in this case by a larger amount!). The real reason the call calendar is attractive is because the short call option decays at a much faster rate than the long call option.
In fact, one of the best ways of thinking about this trade is to analyze how much you receive per day to enter the trade versus how much it costs you per day to enter the trade.
Long Call: $6.20, 68 days to expiration @ $0.09 per day cost to enter trade
Short Call: $1.00, 5 days to expiration @ $0.20 per day received to enter trade
Since we receive more than we spend on a daily basis we might conclude this is a good trade provided we are not expecting tremendous volatility in the underlying stock over the next 5 trading days.
The Volatility Argument
But what happens if there is a good deal of volatility?
In the above trade if the stock dropped $5 or rose $5 what would the result be? Let’s first consider what would happen if the stock dropped $5.
To quickly figure out what each option would be worth if the stock dropped $5 we could simply figure out what the options $5 above the current strikes are worth (obviously those options $5 higher on the chain at trade entry have similar values to what the strike 110 options would have if the stock dropped $5).
A quick glance at the options indicates that the long call option would decrease to $4.00 (the bid value of the 115’s in July at time of writing which is the price we would receive if we were to close the trade) and the short call would decrease to $0.20 (the Ask price of the 115’s in May and the price we would have to pay to close the trade if we wished).
So the long call loss would be $2.20 (from $6.20 Ask to $4.00 Bid) and the short call gain would be $0.80 (from $1.00 Bid to $0.20 Ask).
Overall the trade would be at a loss of $1.40. Now this isn’t so bad if we continue shorting options against the long option in June. What if the drop was more severe, say $15? Working through the math the bottom line is the trade would be down $3.70 making it much more difficult to get back to breakeven within a month by shorting June options.
A similar analysis when considering a $15 move up yields a gain of $9.90 on the long option but a loss of $12.95 on the short option for a total loss of $3.05.
The bottom line is that we have had to take $5.20 out of our pockets with the hope of making $1.00. While small changes in the stock price should still keep the trade profitable, we might be risking $3.70 or $3.05 (i.e. 71% or 58% respectively) of our initial net debit, $5.20, should the stock makes a substantial move up or down. So, let’s see how to reduce that risk and potentially increase our reward %:
Lower $ Risk, Higher % Reward Calendar Trade
While more often than not it is prudent to separate call calendar options instruments by more than a month, discretion can be exercised when considering the trade during the final week of expiration. [The reason you generally want your options to be separated by more than a month is that both options have relatively similar time decays and relatively high implied volatilities with just a couple of months to go to expiration. So ensuring the options are placed more than a month apart ensures the short option is decaying at a much higher rate than the long option and the implied volatility on the long option is considerably lower typically than that of the short option.]
With just 5 days to go to expiration, time decay is not going to have a significant impact on the long option in June so we could consider the purchase of a June 110 option for $3.40 instead of going all the way out to July for $6.20. Using the same $1.00 credit from the May short option the risk would then be:
Risk = $3.40 – $1.00 = $2.40
Return on Risk = $1.00 / $2.40 = 41%
41% in 5 trading days neglecting commissions and slippage is obviously much more attractive than the 19% that could be achieved using July options plus the risk in dollar terms is reduced from $5.20 to just $2.40 – a 53% reduction in risk!
So, when trading calendar positions, stick to the general rules of 3-6 months for long options, 1 month or less for short options but feel free to reduce the long option timeframe to 2 months or even 1month when you are approaching expiration wee.
Trade Safely & Have A Great Week,
OptionSage
