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An Options Strategy for Sideways Markets and High Volatility

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As we find ourselves at the end of April, the S&P 500 is essentially unchanged on the year, down just over 1%.  During a four month period in which we’ve seen several major market moves, the end result so far has been essentially no movement.

Implied volatility, as measured by the CBOE Global Markets (CBOE - Free Report) VIX index, is slightly above its multi-year average, but has been above 30 this year.

What if you had the idea that, after earnings season and heading into the summer, the market was going to spend the next few months in the doldrums, going essentially sideways?  But that jittery expectations for volatility might remain high.  Is there an options trade you could do to earn extra income during the slow period?

Absolutely. (Actually there are several, but let’s concentrate on one that features limited risk.)

The Calendar Spread

A calendar spread involves buying one option (call or put) and selling one option (the same call or put) on the same underlying and on the same strike but with a different expiration date.  If we buy the longer dated option and sell the shorter dated option, we are said to be “long” the calendar spread. If we sell the longer dated option and buy the shorter dated option we are “short” the spread. 

As we saw in the article on options greeks (read it here), all else being equal, options with less time remaining until expiration decay faster than options with more time to expiration.  Options with more time remaining until expiration have more vega, - sensitivity to changes in implied volatilities - than near term options.

This means if we are long a calendar spread, the option that we are short will lose its value faster than the option we are long.  This works in our favor if the market sits still.  It really doesn’t matter if the spread is composed of calls or puts, as long as it is at the money when we initiate it.

If market implied volatilities increase, the farther term option we are long will increase in value faster than the option we are short.

Example:

If a stock is trading $80, the 80 call with 1 month remaining is trading $4 and the 80 call with 4 months remaining is trading $6, the value of the spread (the difference between the prices) is $2.  Let’s say we buy the 4 month call and sell the 2 month call for a debit of $2. 

We want to stock to trade sideways, not move at all, or at least come back to basically where we started before the first expiration, and we want the markets expectation for movement to increase.

At the first expiration, three things can happen.

1)      If the stock is at or near the strike of the near term option, it will lose all of it’s time value and the option we own will still have value and can be sold for a potential profit (assuming it’s worth at least $2.)  If it’s worth $4, we make $2.  The higher implied volatilities are at that point, the more our long option is worth and the more we make.

2)      If the stock is much lower than our strike, the near term option will expire worthless and the option we are long will likely have lost much of its value and can either be sold to recoup some of the $2 premium we spent or held to expiration on the off-chance the stock rallies and it’s worth a lot by the second expiration.

3)      If the stock is much higher than our strike at the first expiration, both options will be in the money.  The first option will be assigned and we will be short 100 shares of stock, but long an option to buy it back at the same price.  Just as in scenario 2, our maximum loss is the total we paid for the spread - $2. We even have some potential to make money in this situation, because we are short the stock at $80 and can buy it for $80 if we want, but are not obligated to.  So if the stock is below $80 at expiration, we can buy it at the market price instead and pocket the difference.  (Effectively, at this point we own a combination of assets that acts just like the 80 put. – More on this and the concept of put-call parity in a future piece.)

This is an example of an options trade where our risk is entirely defined, that will be modestly profitable if our market prediction is correct, and even has basically unlimited upside potential in the rare cases where things work exactly right for us.




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