With earnings season unbelievably upon us in a few short weeks, it might be a good time to talk about a subject that is brought up quite often in MTM Group Coaching and Online Education and is often debated by option traders learning to trade advanced strategies; double calendars vs. double diagonals.
Double Calendars vs. Double Diagonals
Both double calendars and double diagonals have the same fundamental structure; each is short option contracts in nearby expirations and long option contracts in farther out expirations in equal numbers. As implied by the name, this complex spread is comprised of two different spreads. These time spreads (aka known as horizontal spreads and calendar spreads) occur at two different strike prices. Each of the two individual spreads, in both the double calendar and the double diagonal, is constructed entirely of puts or calls. But the either position can be constructed of puts, calls, or both puts and calls. The structure for each of both double calendars or double diagonals thus consists of four different, two long and two short, options. These spreads are commonly traded as “long double calendars” and “long double diagonals” in which the long-term options in the spread (those with greater value) are purchased, and the short-term ones are sold. The profit engine that drives both the long double calendar and the long double diagonal is the differential decay of extrinsic (time) premium between shorter dated and longer dated options. The main difference between double calendars and double diagonals is the placement of the long strikes. In the case of double calendars, the strikes of the short and long contracts are identical. In a double diagonal, the strikes of the long contracts are placed farther out-of-the-money) OTM than the short strikes.
Why should an option trader complicate his or her life with these two similar structures? The reason traders implement double calendars and double diagonals is the position response to changes in IV; in other words, the vega of the position. Both trades are vega positive, theta positive, and delta neutral—presuming the price of the underlying lies between the two middle strike prices—over the range of profitability. However, the double calendar positions, because of the placement of the long strikes being closer to ATM, responds favorably more rapidly to increases in IV while the double diagonal responds more slowly. Conversely, decreases in IV of the long positions has a negative impact on double calendars more strongly than it does on double diagonals.
If you have only traded a single-legged calendar or diagonal through earnings season even not during earnings season, it might just be time to give them a look. Maybe you have never traded a calendar or a diagonal. This might be the time to find out about these time spreads. Once a single position spread makes sense, a double might make even more sense and be more profitable too.
We all know options are derivatives, and their prices are derived from the underlying stock, index, or ETF. But with other factors at work such as implied volatility, time decay and the constant changing of prices, it may be difficult to gauge how much option prices will change. Certainly these are all important factors to consider when pricing options. But have you ever wondered how much an option is going to change with respect to say the underlying? Very simple – check out its delta.
Delta is arguably the most heavily identifiable Greek (unless you count Socrates or Aristotle) especially by individuals learning to trade options. It offers a quick and relatively easy way to tell us what to expect from our option positions as we watch the price action of the underlying. Calls have positive deltas, as they typically move higher on a rise in the stock, and puts have negative deltas, as they typically move lower when the stock rises.
While some investors view delta as the percentage chance an option has of expiring in-the-money, it is really more of a way to project expected appreciation or depreciation. A delta of 0.50 for an AAPL call option suggests the option should move 50 cents higher when the AAPL moves up by a dollar, and lose 50 cents for every dollar AAPL moves lower.
But delta is only foolproof when all other factors are held constant, which is rarely the case (and certainly never the case for time decay). As option traders know, time decay is inevitable for all options particularly hurting long positions due to option premiums shrinking due to the passing of time. If an option is moving more (or less) than its delta would suggest, it is likely because other variables are shifting. For example, buying demand might be pushing implied volatility higher, raising the price of the options.
Still, this king of all Greeks is a good starting point for gauging how your options are likely to move. Option traders should consider mastering this option greek before moving on to the other greeks. Here at Market Taker Mentoring, we have many programs to teach you about option delta and much much more about all things options by experienced professionals. As Socrates once said, “Employ your time in improving yourself by other men’s writings, so that you shall gain easily what others have labored hard for.”
Now that Apple’s earnings announcement is behind us, it may be a good time to take another look at the technology giant. With the volatility event over, you might be looking to implement an option position. Even though the company announced its earnings, there may still be some volatile action ahead as the market heads towards the holidays. Here are a few thoughts that should be considered on AAPL or any other position you may enter.
Learning to trade options offers a number of unique advantages to an option trader, but perhaps the single most attractive characteristic is the ability to control risk rather precisely in many instances. Much of this advantage comes from the ability to control positions that are similar to stock with far less capital outlay.
One particular form of risk control that is often dismissed among option traders is the time stop. Time stops take advantage of the time decay (theta) and can help control risk. It is important to understand that this time decay is not linear by any means.
As a direct result, it may not be apparent the course the time decay curve will follow. An option trader has to take into account that the option modeling software that most online brokers have is essential to plan the trade and decide the appropriate time at which to place a time stop. This of course is dependent on how much risk the option trader is willing to take concede due to time decay as part of the whole risk element of the trade. Other risk factors include delta, gamma and theta just to name a few.
As an example, consider the case of a bullish position in AAPL implemented by buying in-the-money December 105 calls. A trader could establish a position consisting of 10 long contracts with a position delta of +700 for approximately $5,000 as I write this.
At the time of this writing, the stock is trading around $109; these call options are therefore $4 in-the-money. Let’s assume a trader analyzes the trade with an at-expiration P&(L) diagram and wants to exit the trade if AAPL is at or abelow $106 (where potential support is at) at expiration. The options expiration risk is $4,000 or more. However, if the option trader takes the position that the expected or feared move will occur quickly—long before expiration—he could implement a time stop as well.
Using a stop to close the position if the stock gets to $106 at a point in time around halfway to expiration would reduce the risk significantly. Because the option would still have some time value, the trader could sell the option for a loss prior to expiration, therefore retaining some time value and and the option having a higher price. In this scenario, closing the position prior to expiration helps the trader lose less when the stop triggers. This is especially true if there is a fair amount of time until expiration and time decay hasn’t totally eroded away the option premium.
As one can see, options offer a variety of ways to control risk. An option trader needs to learn several that match his or her risk/reward criteria and personality.
A calendar spread, or what it is sometimes referred to as a time spread or horizontal spread can be a simple and quite useful option strategy. The calendar spread is designed to work somewhat like a covered call but without the potentially huge outlay of cash that can accompany buying shares of stock. The spread profits from time decay (option theta) and can make money in any direction depending on the strikes that are chosen. The spread can be set-up with a bullish, bearish or neutral outlook on the underlying either using call options or put options.
How to Create a Calendar Spread
Creating a calendar spread involves buying and selling options on the same underlying with the same strikes but different expirations. The best case-scenario is for the stock to finish at the strike price allowing the short-term option to expire worthless and still have the long option retain much of its value.
For the sake of this example, close to at-the-money (ATM) options will be used but out-of-the-money (OTM) and in-the-money (ITM) options can also be used depending if there is a bullish or bearish bias. As a general guideline, if I have a bullish outlook on the underlying I use call options and put options for a bearish bias. The reasoning is that OTM options generally have tighter bid/ask spreads than options that are currently trading ITM. Initially being down less money entering any option trade due to a tighter bid/ask spread is always a good thing.
Simple to Follow Example
In late August, Marriot International (MAR) was trading just over $69. The stock has been slowly rising over the last year. The trader forecasts that the stock will still be about the same price or maybe a tad higher by September expiration. This scenario makes it worthwhile to look at a calendar spread. MAR has September and October expiration’s available. The trader can buy the October 70 call for 1.25 and sell the September 70 call for 0.55. The total cost of the calendar spread is 0.70 (1.25 – 0.55) and that also represents the most that can be lost.
If the stock remains relatively flat as September expiration approaches, the calendar spread’s value should increase. Hypothetically, with about a week left until September expiration the October 70 call might be worth 1.00 and the September 70 call might drop to 0.15. The spread now would be 0.85. A profit could now be made of $0.15 (1.25 – 0.55). That doesn’t sound like much but a $0.15 profit on a $0.70 investment in a couple of weeks is not a bad return in my opinion.
The whole key to the success of the calendar spread is the stock must not have huge price swings. If the stock falls more than anticipated, the spread’s value will decline along with the stock. If the stock rises well above $70, the short September 70 call will partially or fully offset the increase in the long October 70 call depending on how much the stock rises.
There are other factors that can affect a calendar spread like implied volatility skews that can both help and hurt the spread. It is advantageous for the implied volatility to be higher for the short option versus the long option. This way the more expensive premium is sold and the cheaper is purchased. This component will be discussed in greater detail at a later time.
The beauty of the calendar spread is that it almost functions like a credit spread without the added risk. The risk with a credit spread is that it may suffer a substantially greater loss than a calendar spread if the stock moves in the opposite direction of the outlook due to high risk and low reward scenario that accompanies most out-of-the-money (OTM) credit spreads.
Last week we talked about short-term call options and this week I thought it would be appropriate to discuss short-term put options. The mentality behind short-term put options is probably different than the mentality behind short-term call options. Many times option traders consider short-term put options as a means of protection. With the market extended and the possibility of stocks moving lower in the near future, it might be a good time to talk about put options.
If a trader buys a put option, he or she has the right to sell the underlying at a particular price (strike price) before a certain time (expiration). If a trader owns 100 shares of stock and purchases a put option, the trader may be able to protect the position fully or to some degree because he or she will have the right to sell the stock at the strike price by expiration even if the shares lose value.
Some investors who are looking to protect an investment only consider buying short-term puts, or front-month puts for protection. The problem however, is that there is a flaw to the reasoning of purchasing short-term put options as protection. Similar to short-term call options, the contracts have a higher option theta (time decay) and relying on short-term puts to protect a straight stock purchase is not necessarily the best way to protect the stock.
Although short-term puts may be cheaper than longer expiration puts, if an option trader was to continually purchase short-term puts as protection, it could end up being a rather expensive way to insure the stock particularly if the stock never declines to the short-term puts strike price. If a put option with a longer expiration was purchased, it would certainly cost more initially, but time decay (premium eroding) would be less of a factor due to a smaller initial option theta. Here is an example using short-term put options.
Using a hypothetical trade, let’s say a stock is trading slightly above $13 and our hypothetical trader wants to by the stock because he or she thinks the stock will beat its earnings’ estimates in each of the next two quarters. This investment will take at least six months because the trader is counting on the earning reports to move the stock higher.
Being a smart options trader, our trader wants some insurance against a potential drop in the stock just in case. The trader decides to buy a slightly out-of-the-money September 13 put, which carries an ask price of 0.50 (rounded for simplicity purposes). That $0.50 premium represents almost 4 percent of the current stock price. In fact, if the option trader rolled the short-term put option month after month, it would create a big dent in the initial outlay of cash. After about seven months (assuming the stock hangs around $13 and each monthly put option costs 0.50) the trader would lose more than 25 percent on the $13 investment.
If the stock drops in price, then the ultimate rationalization for the strategy is realized; protection. The put provides a hedge. The value of the option will increase as the stock drops, which can offset the loss suffered as the stock drops.
Buying a put option is a hedge and can be considered a decent insurance policy for a stock investment. Buying short-term put options as a hedge can make it an extra expensive hedge due to time decay (option theta). Option traders and investors can usually find better ways to protect a stock. To learn new and different approaches, please visit the Learn to Trade section of our website.
With the market once again considering a move higher as earnings wind down, it might be a good time to talk about call options. When an option trader buys a call option, he or she has the right to buy the underlying at a particular price (strike price) before a certain time (expiration). Keep in mind that just because the option trader has the right to buy the stock, doesn’t mean that he or she has to necessarily do so. The call option just like a put option can be sold anytime up until expiration for a profit or loss.
A lot of traders especially those who are just learning to trade options can fall in love with call options and especially short-term call options because they are cheaper than call options with longer expirations. We can classify short-term call options as call options that expire in less than thirty days for the sake of this discussion. But there is a potential problem with purchasing short-term call options. The shorter the amount of time that is purchased, the higher the option theta (time decay) will be. The higher the time decay, the quicker the premium will erode away the call option’s premium. The call option may be cheaper due to a shorter time until expiration, but it may not be worth it overall. Let us take a look.
With Tesla Motors (TSLA) trading around $260 last week, an option trader might have considered call options to profit from an expected move higher. He could have purchased the August 260 calls for 3.30 that expired in 3 days. Yes, the options are cheap and yes they will profit if TSLA moves up vigorously in the next couple of days. But the option theta is 0.70 on the call options meaning they will lose $0.70 for everyday that passes with all other variables being held constant, In fact if the stock trades sideways, the option theta will increase the closer it gets to expiration since there is currently no intrinsic value (the in-the-money portion of the option’s premium) on the call options.
If an option trader purchased the September 260 calls for TSLA, it would have cost him 12.00 and it would have made the at-expiration breakeven point of the trade $272 (260 + 12) versus only $263.30 (263 + 3.30) with the August call options. But the major benefit to buying further out is option theta. The September 260 calls had an option theta of 0.15 meaning for every day that passes, the option premium would decrease $0.15 based on the option theta and all other variables being held constant. This is certainly a smaller percentage of a loss based on option theta for the September options (1.25%) versus the August options (21.21%) especially if the stock trades sideways or moves very little.
Fast forward to August expiration, TSLA closed basically at $262. The August 260 call would have expired with an intrinsic value of $2 (262 – 260). If the option trader did nothing up until expiration, the long August 260 call would have lost $1.30 (3.30 – 2) because there would be no time value (option theta) left and only the intrinsic value. The September 260 call would have lost approximately $0.45 (3 X 0.15) in theta but also gained $1 (2 X 0.50) from delta based on a delta of 0.50 and a $2 (262 – 260) move higher. The September 260 calls would now be worth $12.55 (12 + 0.55) and profited $0.55 (12.55 – 12).
Having enough time until expiration is a critical element when an option trader is considering buying options like the call options we talked about above. Keep in mind that as a general rule, options lose value over time and the option theta starts to accelerate even more with 30 days or less left until expiration. Buying a call option with more time until expiration will certainly cost more than one with less time but the benefits, including having a smaller option theta, might be worth the more expensive price especially if the underlying fails to move higher.
Another topic that is brought up often in my Group Coaching class is buying call options and put options outright. When option traders first get their feet wet trading options, they often just buy call options for a bullish outlook and put options for a bearish outlook. In their defense, they are new so they probably do not know many if not any advanced strategies which means they are limited in the option strategies they can trade. Buying call options and put options are the most basic but many times they may not be the best choice.
If an option trader only buys and for that matter sells options outright, he or she often ignores some of the real benefits of using options to create more flexible positions and offset risk.
Here is a recent example using Twitter Inc. (TWTR). If an option trader believed TWTR stock will continue to rise like it has been doing, he could buy a July 39 call for 1.80 when the stock was trading at $38.50. However the long call’s premium would suffer if TWTR stock fell or implied volatility (measured by vega) decreased. Long options can lose value and short options can gain value when implied volatility decreases keeping other variables constant.
Instead of buying a call on TWTR stock, an option trader can implement an option spread (in this case a bull call spread) by also selling a July 42 call for 0.75. This reduces the option trade’s maximum loss to 1.05 (1.80 – 0.75) and also lowers the option trade’s exposure to implied volatility changes because of being long and short options as part of the option spread. This option spread lowers the potential risk however it limits potential gains because of the short option.
In addition, simply buying call options and put options without comparing and contrasting implied volatility (vega), time decay (theta) and how changes in the stock price will affect the option’s premium (delta) can lead to common mistakes. Option traders will sometimes buy options when option premiums are inflated or choose expirations with too little time left. Understanding the pros and cons of an option spread can significantly improve your option trading.
There are so many different characteristics of options that I talk a lot about with my options coaching students. But one of the more popular subjects is that premium sellers see the most dramatic erosion of the time value of options they have sold during the last week of the options cycle. Most premium sellers strive to keep the options they have sold short (also known as options they have “written”) out-of-the-money (OTM) in order that the entirety of the premium they have sold represents time (extrinsic) premium and is subject to this rapid time decay.
With 12 monthly cycles, there historically have been only 12 of these final weeks per year in which premium sellers have seen the maximum benefit of their core strategy. The widespread use of weekly options has changed the playing field. Options with one week durations are available on several indices and several hundred different stocks. These options have been in existence since October 2005 but only in the past couple of years have they gained widespread recognition and achieved sufficient trading volume to have good liquidity. Further now, there are weeklys that go for consecutive weeks (1 week options, 2 week options, 3 week options, 4 week options and 5 week options) that were just late last year.
Standard trading strategies employed by premium sellers can be executed in these options. The advantage is to gain the “sweet spot” of the time decay of premium without having to wait through the entirety of the 4 to 5 week option cycle. The party never ends for premium sellers using these innovative methods. Of course there is a trade-off because the shorter the time there is left until expiration, the smaller the option premiums are compared to an option with a longer expiration. As option traders we are used to tradeoffs.
Traders interested in using these weeklys MUST understand settlement procedures and be aware of last days for trading. An excellent discussion of weeklies given by Dan Passarelli is available at Learn to Trade Weeklys.
With the market threatening to move lower after a bullish run last year and earning’s season upon us,it might be a good time to talk about put options. If a trader buys a put option, he or she has the right to sell the underlying at a particular price (strike price) before a certain time (expiration). If a trader owns 100 shares of stock and purchases a put option, the trader may be able to protect the position fully or to some degree because he or she will have the right to sell the stock at the strike price by expiration even if the shares lose value.
A lot of traders especially those who are just learning to trade options can be smitten by put options especially buying the shortest-term, or front month put for protection. The problem, however, is that there is a flaw to the reasoning of purchasing front-month puts as protection. Front-month contracts have a higher theta (time decay) and relying on front-month puts to protect a straight stock purchase is not necessarily the best way to protect the stock. If you were to continually purchase front-month puts as protection, that can end up being a rather expensive way to by insurance.
Although front month options are often cheaper, they are not always your best bet. The idea may be sound, the trader purchases a number of shares of the stock and purchases out-of-the-money puts to protect his or her position; but sound reasoning does not always lead to good practice. Here’s an example.
We will use a hypothetical trade. The stock is trading a slightly above 13 and our hypothetical trader wants to own the stock because he or she thinks the stock will beat its earnings’ estimates in each of the next two quarters. This investment will take at least six months as the trader wants to allow the news events to move the stock higher.
Being a smart options trader, our stock trader wants some insurance against a potential drop in the stock just in case. The trader decides to buy a slightly out-of-the-money July 13 put, which carries an ask price of $0.50 (rounded for simplicity purposes). That 0.50 premium represents almost 4 percent of the current stock price. In fact, if the investor rolled option month after month, it would create a big dent in the initial outlay of cash. To be sure, after about seven months (assuming the stock hangs around $13) the trader would lose more than 25 percent on the $13 investment.
If the stock drops in price, then the ultimate rationalization for the strategy is realized; protection. The put provides a hedge. The value of the option will increase as the stock drops, which can offset the loss suffered as the stock drops. Buying the put is a hedge and and a solid insurance policy – though, albeit, an expensive one. Investors can usually find better ways to protect a stock.
One of the major differences when learning to trade options as opposed to equity trading is the impact of time on the various trade instruments. Remember that option premiums reflect the total of both intrinsic (if any) and extrinsic (time) value. Equities are not affected by the passing of time unlike many movie stars. Even though Christie Brinkley is still considered to be still quite attractive by many, her look is not the same as it was decades ago when she was a top model and cover-girl. Also remember that while very few things in trading are for certain, one certainty is that the time value of an option premium goes to zero at the closing bell on expiration Friday.
While this decay of time premium to a value of zero is reliable and undeniable in the world of option trading, it is important to recognize that the decay is not linear. It is during the final weeks of the option cycle that decay of the extrinsic premium begins to race ever faster to oblivion. In the vocabulary of the options trader, the rate of theta decay increases as expiration approaches. It is from this quickening of the pace that many examples of option trading vehicles gain their maximum profitability during this final week of their life.
Some of the most dramatic changes in behavior can be seen in the trading strategy known as the butterfly. For those new to options, consideration of the butterfly represents the move from simple single legged strategy such as simply buying a put or a call to multi-legged strategies that include both buying and selling options in certain patterns.
To review briefly, a butterfly consists of a vertical debit spread and vertical credit spread sharing the same strike price constructed together in the same underlying in the same expiration. It may be built using either puts or calls and its directional bias derives from strike selection rather than the particular type of option used for construction. For a (long) butterfly, maximum profit is always achieved at expiration when the underlying closes at the short strike shared by the two vertical spreads.
The butterfly has the interesting characteristic in that it responds sluggishly to price movement early in its life. For example in the first two weeks of a four week option cycle, time decay or theta is slow to erode. However, as expiration approaches, the butterfly becomes increasingly sensitive to price movement as the time premium erodes and the spread becomes increasingly subject to delta as a result of increasing gamma. It is for this reason that many butterfly traders restrict their use to the more responsive part of the options cycle. For a butterfly, the greatest sensitivity to time (and, therefore, profit potential) is reaped in the final week of the life cycle of the butterfly, i.e. expiration week. Beauty is in the eye of the beholder!
Options involve risk and are not suitable for all investors. Before trading options, please read Characteristics and Risks of Standardized Option (ODD) which can be obtained from your broker; by calling (888) OPTIONS; or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, IL 60606. The content on this site is intended to be educational and/or informative in nature. No statement on this site is intended to be a recommendation or solicitation to buy or sell any security or to provide trading or investment advice. Traders and investors considering options should consult a professional tax advisor as to how taxes may affect the outcome of contemplated options transactions.