Option Investor
Newsletter

Portfolio Activity

HAVING TROUBLE PRINTING?
Printer friendly version
BBH Blasts Off!

The Biotech HOLDRS Trust (AMEX:BBH) soared to recent highs Monday, climbing nearly 10% on news that Genentech's (NYSE:DNA) oncology drug Avastin had been shown to be effective in battling lung cancer in late-stage clinical trials. Genentech is easily the largest holding in the BBH, accounting for roughly 33% of its value, thus it came (belatedly) as little surprise that the index was so significantly affected by just one bullish stock.

What is surprising is how quickly our successful spread moved to the "watch" list and while we don't want to write-off the position as a loss before its time, there is certainly a need to plan for a potential exit or adjustment. Readers who have been following the saga of the LM Ericsson (NASDAQ:ERICY) position know about our recent discussion of the calendar spread and this event may provide a good opportunity to test the strategy with a portfolio position.


The Concept of Selling Time

A calendar spread (also known as a horizontal or time spread) involves the purchase of an option with one expiration date and the sale of another option with the same strike price but a different expiration date. The philosophy for using calendar spreads is that time will erode the value of the short term option at a faster rate than it will the long term option. A spread that is established when the underlying stock is at or near the strike price of the options used is a neutral spread. If the price of the issue remains relatively unchanged until the near-term option expires, the neutral spread will make a profit.

It is important to understand how a calendar spread profits from the passage of time. When opening a horizontal spread, you buy a long term option and sell a short term option. Both options have the same exercise price, thus they have the same intrinsic value. Regardless of the movement of the stock, time value will always be less in the near term option. As long as the underlying stock price remains relatively close to the exercise price, the value of the spread will be determined by the (time value) premium in each option. When you close the position at expiration, the remaining time value in the short term option will be very low relative to that of the long term option.

As you might expect, a horizontal spread is completely dependent upon the relative behavior of time-value decay in each of the option positions. Since the profitability of success for this strategy is determined solely by the difference in time values of the options, it is important for the underlying issue to remain near the sold strike price, where (time value) premium is theoretically the highest. If the stock price is at the high or low extreme, the time values of both options will be low and the position will likely incur a loss; the remaining credit will be less than the opening debit.

To the average trader, it would appear this technique can't lose money. One would simply buy the longer-term option and sell the shorter-term option. As both time values decayed, the spread would gain value. In reality, it's rarely that easy because the underlying stock does not remain constant. However, one way to reduce the negative effects of a volatile stock is to establish the spread at least two to three months before the near-term option expires, capitalizing on the ability to sell a second position against the longer-term option. Ideally, the stock price would be just below the sold strike when the near-term options expire. If (at expiration) the options are in-the-money, they must be re-purchased to preserve the long-term position.


General Considerations for Calendar Spreads:

1) The forecast for the underlying issue should be a relatively small trading range. Any substantial moves up or down will reduce the probability of profit for the position.

2) If possible, the options you sell should be overvalued relative to the options you buy.

3) It helps if implied volatility is low with some potential for an increase. This condition will boost the premium of the options you purchase, which have more time value remaining than the options you sell.


Implementing the Strategy

In the case of the BBH, a trader could purchase the JUL-$145 call for roughly $7.50 per contract (currently $6.90 X $8.40) and sell the existing APR-$50 call for a credit of approximately $1.50 (currently $1.30 X $1.80). After allowing for the initial $0.50 credit in the (bear-call) spread, the total debit for the JUL-$145C/APR-$145C calendar spread would be near $5.50 per contract. Once the transition has been made, he would wait for time to pass. If the BBH moves in a small range and ends the expiration period near the sold strike, he could simply sell the JUL-$145 calls to close the position. If the outlook remains relatively neutral and the option premiums are robust, he might sell the MAY-$145 calls to reduce the cost basis in the longer-term position, hoping to earn a greater profit when the JUL-$145 calls are eventually sold.

Unfortunately, a common problem with this strategy in a bullish market environment is the issue (BBH) moves above the strike price of the sold option before it expires, causing the spread to lose value (and often forcing an early exit in the entire play). While it is acceptable for the short option to be "in-the-money" for brief periods, a position adjustment is generally more profitable if the trend is expected to continue for any length of time. In fact, it has been our experience that "rolling-out" early is almost always preferable to a last minute rescue attempt with a stock (or index) that is no longer trading as expected.

With limited-profit combinations, the need for adept spread management is obvious, but it's not always as difficult as it seems and we'll talk more about the various techniques as this play progresses. At the same time, we caution less-experienced readers that this particular strategy is not appropriate for every portfolio, nor should it be used by anyone who is not completely comfortable with common position adjustments or the additional capital draw-downs associated with these transactions. As with any trade, you should predetermine the profit zone (the price range where the underlying has to remain for the play to be successful) and specify the initial exit or adjustment points before opening the position.

Trade Wisely!

Monthly Cash Machine Newsletter Archives