Wednesday, July 26, 2006

Trading P.I.T. Session 5

In tonight's Trading P.I.T. class, Bill Keevan presented Call and Put Calendar Spreads. Calendar Spreads are a powerful way to profit from stagnation in a stock. If you're familiar with Covered Calls, you've got a head start on understanding the basic strategy.

Without going into much detail about a Covered Call strategy, the basic idea is that you own the underlying security and sell the Out of The Money (OTM) Call for a market premium. Doing so limits your downside risk by the amout of the market premium, and if the stock doesn't move at all, you make a nice profit on the sale of the Call Option. If the stock goes down, you've offset your losses by the premium you took in with the sale. If the stock moves above the strike price, the option will be exercised; you'll make a nice profit, while limiting your risk, but will be out of the stock and unable benefit from further increases in the stock's value. You can make a nice percentage return using Covered Calls, but owning the stock ties up a considerable amount of your money and although you gain some downside risk protection, it's only offset by the amount you were paid for writing (selling) the call.

In a Call Calendar Spread we will buy a long-term Call Option (say 6 months out); this is akin to owning the stock like in the covered call strategy described above. We then sell another, short-term Call Option and take in the premium. By doing so, we don't have to tie up as much of our capital; this is the way we use the leverage that Options provide to make considerably more reward on risk. We can typically expect 4-8 times the reward on risk using a Call Calendar Spread instead of a Covered Call. In either the Covered Call or the Call Calendar Spread, we achieve maximum profits if the underlying security rises to, but does not exceed the Strike Price of the Call Option we sold. If the stock does rise above the strike price on the option we sold, we will be exercised and need to either buy back the short-term option or perform a same day substitution cover the Option we sold.

To me, this is the most complex strategy to describe profitability, especially without having a risk graph. Basically, when you combine the options in a risk graph, you'll see a range of profitability at expiration with fairly steep slopes around a peak that is centered above the strike price of the option we sold.

There are many ways to structure a Calendar Spread. Unlike a Covered Call, you can take advantage of a stagnant-to-bearish outlook by using a Put Calender Spread. The flexibility of this trade adds to the complexity. You can choose to structure the spread At The Money (ATM), Out of The Money (OTM) or even diagonalize the spread by buying and selling different strike prices. By comparing the difference in premiums between the options, you can choose which spread will match your outlook.

In order to make the most informed decision between the variations on this trade, it is a tremendous help and time savings to compare the risk graphs by using OPUS or another Options Analysis program. Of course the tools of the trade (yes, pun intended) cost you money, but consider this: If you're building a house, but are not willing to buy a nail gun, it will probably cost you more in labor than you saved on the tool.

2 comments:

Anonymous said...

Thanks for sharing your experience. I'm considering taking the 3-day class. I have no backgound in market investing. My dumb question: A friend showed me Scottrade and mentioned other 'free' tools. What are they worth compared to the TMTT tool you use? Am coming thru as anonymous - name is Ron.

Trader Taocode said...

Hi Ron, I'm not familiar with Scottrade nor any of the tools they provide. I know you can pull up pretty good technical charts on http://finance.yahoo.com and they're absolutely free. With Yahoo you can even add stocks to a porfolio, all you need is a free yahoo account. All the brokerage firms (and a ton of other sites like www.bigchart.com) seem to provide free trading tools.

I've recently been playing with Interactive Brokers' (IB) charting and analytics tools. IB even has some risk graphs for analyzing your portfolio, including options! I don't think it's nearly as good a tool as OPUS, but I'm just learning what it's capable of.