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Educational Article

Calendar Spreads: A Nice Way To Sleep At Night, Part 1

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Because traders have a limited attention span and we writers have a constraint on the length of our articles, this article will be spread over two weeks.

Calendar spreads are really an easy yet at the same time a more sophisticated option strategy. I've written about calendar spreads before but I thought I'd write about it again because it's a good way to explain some "option basics" for the beginner trader while at the same time offer a more sophisticated trade for those of you who have been burned by straight directional trades (buy a call or put). I'm assuming there aren't too many of you brave soldiers that still have enough capital to be going naked. I will try to give a fair amount of explanation to each of my points below but if you still don't understand a point, go dig out some books. I have found over the years that sometimes one writer can explain things in such a way that it seems simple while other writers make it sound so complicated. Unfortunately, different readers respond to different writers in very different ways. Now on to the topic at hand - the calendar spread using January '02 and January '03 puts with a strike price of $80 using prices generated February 23rd.

Definition:
The calendar spread is sometimes called a time spread.

Components:
1. A short position
2. A long position with a longer timeframe,
3. Using all calls or all puts
4. The same strike price is used for both legs.
5. Cost is minimal
6. Maximum Risk is the cost of the trade
7. Reward can be very high, usually 2 to 8 times your investment, depending on your time frame.

Maximum reward is obtained when the stock closes at the strike price you chose at expiration of the shorter month. In this case, the January '02. The example I will use would be to buy a January '03 put with an 80 strike on QQQ and sell a January '02 put with an 80 strike on QQQ. I personally like to deal with puts, because the prices are usually cheaper than calls. In this example, if the QQQ's close at 80 on expiration day of January '02 (the shorter leg), then the short leg (the January '02 put) will expire worthless and you will have an "at-the money" put with one year left to expiration that you can sell. This is the part that a lot of people have trouble with and it is what prevents them from doing this trade.

IMPORTANT CONCEPT: It is very important to understand that the current price of the January '02 "at-the-money" option (strike of approximately 50) is a good approximation for what the January "03 80 put will be worth in January '02 if the QQQ are at 80. The current price of the January "02 50 put has almost a year left and is currently worth about $7.40. If the QQQ's are at 80 at expiration in '02 then the 80 strike price would be "at-the-money" and worth at least $7.40, probably more.

Some reasons for doing a calendar spread:
1. Don't have time to watch the market, minute by minute
2. Don't have a lot of trading capital (left).
3. Not as confident in trading ability anymore
4. Like to sleep well at night
5. Like a limited risk strategy with potential high returns
6. Like to make money, even when you are wrong

Criteria for doing a calendar spread:

1. Find a stock that has been slammed and was at a MUCH HIGHER point in the past. That's not too hard to do these days. Try any stock in the Nasdaq 100, or maybe just try the Nasdaq 100 by looking at the QQQ's. I'll use QQQ in my example.

2. Find a stock where the shorter-term option has higher volatility than the longer-term option. Understanding how to play volatility will greatly increase your odds for success in any option trade. Volatility is a main component in option pricing and if you don't understand it, you need to. Volatility is the measure which the stock is expected to move up or down in a given period of time.

There are two types of volatility: historical and implied. Historical volatility is calculated based on the actual change of prices in the past. Implied volatility is what the market maker believes the stock will move and is calculated using a complicated model which then becomes a factor in the option's price. The higher the implied volatility relative to historical volatility, the more expensive the option. For this reason, you want to be a buyer of low volatility and a seller of high volatility. Looking at the QQQ's we see that the months farther out have lower implied volatility than the closer months. Most trading platforms give you implied volatility of the option. Therefore, the QQQ's remain a candidate for this trade because the implied volatility of the January '02 options which we would be short is more than the January '03 options which we would be long.

3. Find a stock where the current implied volatility (20-day) is lower than the average yearly historical volatility. Don't confuse this with #2 which discusses differences in volatility between the months. If the volatility as a whole is relatively low in relation to where the volatility has been in the last year, your position will benefit from a rise in volatility. Historical volatility over the last year has ranged from .42 to .69, and currently is at .43 at the low end of the range. Therefore, the price of our options will increase in value if volatility increases.

Our long January '03 80 put will rise in value if the volatility is higher than the current volatility because implied volatility is a main component of option pricing as discussed above. If volatility at expiration is the same as it is currently, then our "guesstimate" of $7.40 is a good one. I like to be conservative, so I would base my risk/reward calculation using this number, knowing that my odds are greatly increased if there is a rise in volatility. If you don't have the ability to get this information, don't worry, it is not as important, it just gives you a little bit better edge.

The Last four criteria will be covered in detail next week:

4. Determine the most appropriate time frame to trade.
5. Determine the most appropriate strike to use.
6. Select the number of contracts that are optimal for your trading plan.
7. Learn how to calculate your risk to reward using different strikes and timeframes.
8. Find the approximate value of your spread at expiration if you are wrong.

Pay particular attention to "IMPORTANT CONCEPT" above and go back and try it with other stocks that you trade. Don't try this out without the benefit of the criteria 4 thru 8. So stay tuned and come next week armed with your best candidates and learn how to further improve your odds of being successful by using criteria 4 through 8. Just master 1 through 3 this week and pick a book on options and read everything you can about volatility--your bank account will thank you.

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