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.Figure 1 – Original CSCO Directional Calendar Spread (Courtesty OptionsAnalysis.com)
Figure 2 – Original CSCO Direction Calendar Spread risk curves (Courtesty OptionsAnalysis.com)
Figure 3 – CSCO trade as of 5/14/15 (Courtesty OptionsAnalysis.com)
Figure 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).
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.”
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.