An Update on ‘An Option Strategy to Put the Odds on Your Side’

  • SumoMe

         See also One More Plunge for Crude Oil?

A short while back I wrote a piece detailing an option strategy that can improve your odds of profit.  This strategy is typically referred to as a “Directional Calendar Spread”.  The trade in the original article involved buying 18 July CSCO 29 calls and selling 12 May CSCO 29 calls.  The details appear in Figures 1 and 2 below.5Figure 1 – Original CSCO Directional Calendar Spread (Courtesty OptionsAnalysis.com)

6Figure 2 – Original CSCO Direction Calendar Spread risk curves  (Courtesty OptionsAnalysis.com)

Well its expiration day for the May calls and as of the close the day before the original trade now looks like this:3

Figure 3 – CSCO trade as of 5/14/15 (Courtesty OptionsAnalysis.com)

4Figure 4 – CSCO trade risk curves as of 5/14/15 (Courtesty OptionsAnalysis.com)

There are two key things to note about this position:

1) As of the close on 5/14, CSCO stock was trading at $29.05 and the short May call was trading at $0.13 bid/$0.17 ask.  If CSCO closes at $29 or below on expiration day this option will expire worthless and the entire premium will be kept.  So basically there is still roughly $204 of time premium ($0.17 times 12 short option contract) to potentially be captured today (i.e., $204 of additional profit) IF the stock trades lower.

2) On the other hand, if CSCO closes today (May option expiration day) above $29 a share, the May 29 call will be “in-the-money” and the calls that I sold (hypothetically speaking FYI) will be “exercised”, which means that unless I also contact my broker and exercise 12 of my 18 July 29 calls to offset this, come Monday morning my position will be:

a) Long 18 July CSCO 29 calls

b) Short 1,200 shares of CSCO stock (Yikes!)

Did we enter this trade because we want to hold a short position in CSCO stock?  H%^& No!!

So what’s a trader to do!?

Because – in the interest of full disclosure – I don’t want to spend all day writing, rather than discussing all of the possible actions that a trader holding this position could take, I am simply going to choose one and use that as an example (Sorry, it’s just my nature).

One Example Adjustment

For argument’s sake, let’s say:

a) I am still bullish on CSCO

b) No way do I want to wake up Monday morning short 1,200 shares of CSCO stock

c) I am a greedy pig who wants to suck out all of the profit potential I can (again, sorry, it’s just my nature)

I can watch CSCO during the day.  My goal is to capture as much of the potential time decay from the short May option as possible.  Still, I don’t want to take a chance of having the short May calls exercised against me.  So let’s say CSCO stock is still trading at $29.05 towards the end of the day. I can take the following action before the end of the day:

*Buy 12 May CSCO calls (which closes entire position in May calls)

*Sell 15 July CSCO calls (which leaves a position of long 3 July calls)

The net effect of these actions leaves me with the reward-to-risk trade off that appears in Figures 5 and 6 (actually, it would look a little better since I would likely buy back  the May calls at a lower price as the May 29 call drops from $0.17 to $0.05 as time premium vanishes).

5Figure 5 – Adjusted CSCO position  (Courtesty OptionsAnalysis.com)6Figure 6 – Adjusted CSCO position  (Courtesty OptionsAnalysis.com)

The Net Effect

At this point, the position has locked in a profit.  In other words, if this position is held until July expiration and CSCO stock is at $29 a share or less this position will expire with a net profit of $81.  OK, granted $81 isn’t much, but the point is that for the next two months I have a “free trade” with unlimited profit potential.

If you have never found yourself in a trade in which you cannot possibly suffer a  loss no matter how badly things go wrong – and you have unlimited profit potential to boot if things go well – then please take my word for it when I say, “it’s a good feeling.”

Summary

There are many other adjustments that a trader could make instead of the one I’ve highlighted here.  But the main point(s) of this article are:

a) Always be aware of the fact that if an option that you sell expires “in-the-money” you could wake up the next Monday short shares of stock (if you have never learned this lesson the hard way – then please take my word for it when I say, “it’s NOT a good feeling”).

b) If you learn a few basics about options you can put the odds in your favor.

Jay Kaeppel

2 thoughts on “An Update on ‘An Option Strategy to Put the Odds on Your Side’

  1. I hate stock options and I hate calendars. Vega usually surprises-and not in a good way, theta is not linear and Americna style options- why would you put yourself in that position?
    I have several Kaeppel books on my shelf here among all the other option books that I have read, and while I love the cut and thrust of options trading I like the comfort of index options, and never run short near the money positions to expiry. Brave to publish this, even braver to take the trade!

    1. David, excellent points. For the record I am not a huge fan of “neutral” calendar spreads, hence, the variation discussed in the article. Unexpected exercise of short options and a decline in implied volatility (which affects the longer-term option more than the shorter-term option) are definite dangers – that too many traders are not aware of until it is too late. Plus, Murphy’s Law being what it is, every time I would put on a neutral calendar the underlying stock would go berserk. Have made a note to address the downside to neutral calendar spreads in an upcoming post. Jay

Leave a Reply

Your email address will not be published. Required fields are marked *

This blog is kept spam free by WP-SpamFree.