Option Strategy: Calendar Spread Example

Some stocks went up. (Hopefully yours.) Some stocks traded lower. Some stock prices stayed the same. (A few flat lined dead on arrival, many roller coasted up and down back to the starting point.) I was just recently in Las Vegas, for business of course. I enjoy going by the gaming tables. Market research, crowd psychology. Seeing how people bet their cash. Well chips anyway, if bettors had to use real money, they might recognize how much money they just lost. Ever watch people learning to play craps? They’ll use real money. Haven’t they heard of paper trading? Maybe because the pit boss and the other casino employees are always willing to help. Lots of assistance available to make a bet. No matter what color the chips. Gambling and specifically craps have much in common with options: complex risk reward curves. Since the IRS doesn’t allow deducting crap table loses from your income taxes, why would anyone want to throw dice. They can bet options, I mean trade options. Many amateur options traders invest as if they were at a casino. No regards for the odds, just mesmerized by the big potential payoff. Anyone who has been around Wall Street any length of time knows there isn’t many “sure things.” Truly, time’s passing is the only safe bet. In this example we will trade based on Theta alone. We will consider the other “Greeks” asleep. In reality, they are NOT dormant. The fact is, you could set your trades up to minimize their effects. Remember it’s best not to awaken a sleeping giant if at all possible. Our hypothetical example will be four At the Money (ATM) options on a single stock: One month option = $ 1.00 Two month option = $ 1.41 Three month option = $ 1.73 Four month option = $ 2.00 With these hypothetical examples, let’s enter a simple time or calendar spread. We will buy the four month option for $ 2.00 while simultaneously selling the one month option for $ 1.00. Our net cost would be $ 1.00 ($ 2.00 less $ 1.00). Again for demonstration purposes we will not take commissions nor the bid/ask spread into consideration. And also ignore strike prices as well. If everything remained the same except for time’s passage, after one month the option we sold (short position) would be worthless to the buyer. An At the Money (ATM) option has no value at expiration. A $ 1.00 profit to us, offset by the $ .27 loss on our four month turned three month option, brings our position value to $ 1.73. Anyone who can find situations where all the variables remain constant for one month deserves to make 73% on their money. In our perfect example situation, we could now sell another one month option for another Dollar. After the second month, the option we originally bought would have lost half its time, but only $ .59 of its value. Now priced at $ 1.41, the income would be equal to its original cost, $ 2.00. Our cost would be zero. Our profits infinite. Closer to expiration, owning options costs more. Inversely, selling options closer to expiration can pay more. If the one month ATM option is $ 1.00, and the four month equals $ 2.00, then the nine month option would be priced at $ 3.00. Continuing forward, the 16 month option’s price would be $ 4.00 and $ 5.00 would buy the 25 month option. If we could sell one month of time for $ 1.00, we could pay for the 16 month option in four months. Giving us a year of potential for free. Please don’t base trades on any one option pricing component, while ignoring the others. You’ve been given enough information to be dangerous. If you trade with blinders on, you tend to get blind sided. Knowledgeable traders earn the right to have less money at risk and greater potential for profits. Knowledge comes with experience, and experience comes with time, regardless of real chips or paper trades.