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Calendar Spreads: A Nice Way to Sleep at Night, Part 2

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As Paul Harvey says, "And now for the rest of the story." Here is the link for Part 1 that was printed last week to help you review:

Calendar Spreads: Part 1

Part 2:

Criteria for doing a calendar spread:

4. Pick a time frame you are comfortable with. This is a subjective one, but there is no mystery here. The longer the time frame the less sensitive the spread is to fluctuations in the stock. If you would like to just buy an investment and tuck it away, then you should use a long time frame like the January '02 and January '03 as previous discussed. If you want action now, then use a shorter time frame. The shorter the time frame, the more the potential reward as an annual percentage, but with that comes more risk. As they say, "there ain't no free lunch."

5. Pick a strike you are comfortable with. No mystery here either, remember, you are betting that the stock will close at or near your strike price at the expiration of the shorter leg. If you were to use March and April instead of the January '02 and January '03, it is common sense that you wouldn't use 80 as your strike price, unless you think the QQQ's could close at 80 in the next 4 weeks! The strike you choose will be dependent on your market outlook for the next month if using the March and April options. If you think the QQQ's will stay flat, you might choose a 50 strike, if you were moderately bullish you might choose 55, really bullish and you might select 60! The cost of the spread decreases as you move the strike farther above the current price of the stock. The cost of the March-April 50 put calendar spread would cost $1.60 or $1600 for 10 contracts versus $1.20 for the spread using a 60 strike. However, which strike has the greater probability? I'll leave that for you to decide. I prefer to go out longer term and use my capital to put on various positions with greater odds and somewhat less of a reward, therefore, increasing my changes to be right.

6. Select the number of contracts you are comfortable with. I recommend at least 10 contracts when doing this strategy. The reason is that most brokers charge you a minimum ticket, and with the cost of the spread so cheap, it's not worth doing less than 10, or commissions will play a real factor. It also gives you some room to make some adjustments, a topic we can cover in another article.

7. Study different strike and timeframes and calculate your risk to reward. In the case of the January '02/ January '03 puts with a strike of 80, we determined our maximum reward was $7.40, lets say $7 to make it easier to calculate. The cost of the spread would be $1.60 using the "natural spread". The natural spread is buying at the ask and selling at the bid, which the market maker is obligated to fill at. However, you can always squeeze a little out of each leg, and I would conservatively assume we could get this spread down to $1.40 or $1400 for 10 contracts. Now divide $1.40 into the guesstimated actual reward of $7 and you get 5 to 1 odds! That means you make a 500% return in about a year if QQQ go to 80 buy January 02. Maybe you would be more comfortable with a projection of 70, if so then use the prices for 70 strike, which would be a cost of $2.30 for the natural spread or about a 3 to 1 odds. Notice how your reward drops as the strike price drops closer to the actual price of the stock.

8. Find approximate values on your spread at expiration in case you are wrong about the stock. You can do this by looking at current option prices and using those prices as approximations for what options will be worth in the future by changing the time frames and strike prices. If you decide on the QQQ January '02/January '03 80 strike, then how much would your spread be worth if the QQQ's only get to 60 or 70? To figure this, look at the current prices of the January 02 options to approximate the value of your '03 leg at expiration in January '02.

If the QQQ's only get to 60 instead of 80, your short January '02 80 put is worth 20 points, ouch! You would have to buy them back and you would be down $20,000 plus your initial investment of $1400. Don't panic, your January '03 80 put would be worth at least 20 points too, plus 1 year of time value, so all is not lost. You probably could get $1 of time value on the "03 put so your total loss would be about $400 ($1400 cost of spread less $1000 which would be the sale of spread in January '02). Worst-case scenario-- if the stock is "put" to you, in other words you are assigned the stock, simply exercise your long put and move on. You have no extra money at stake and that is truly the worst case. You would lose $1400, the cost of the spread.

If the QQQ's only got to 70 - then the short January '02 80 puts would be worth $10 or $10,000, but your long 80 puts would be worth approximately $12.80 or $12,800, which is the current price of the January '02 60 put. This is the approximation you must master, by using current prices to project the value of your long leg at expiration of the shorter-term option. If the QQQ's get to 70 then your 80 puts would be 10 points in the money. Today, the current strike that is 10 points "in the money" would be the 60 strike because the QQQ's are currently trading for about 50. Looking at the current prices of the January '02 60 puts which are now 10 points "in the money" you would determine that your long 80 put would be worth about $12.80. Subtracting the $10 to buy back the short leg, your profit would be $1400 ($12.80 for the price of the long less $10 price of the short leg less $1.40 cost of the spread originally, times 1000 for 10 contracts). You made 100% in a year and you were 10 points off your projection, not bad.

Really study and understand how to determine the value of your spread at expiration and you will see that this is a worthwhile, low risk, high reward kind of trading. Pay particular attention to #8 and go back and try it with other stocks that your trade.

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