Calendar Spreads Part II

Part II.  Part I can be found here.

Our example position (purchase of 10 Jan-Dec IBM 100 call spreads)
earns the highest profit when December expiration arrives and IBM is trading
just under 100.  Under those conditions, IBM Dec 100 calls expire
worthless and the spread owner sells the Jan100 calls.
  Except on very rare occasions (see below),
you can expect to collect more for the January calls than you
originally paid for the spread.  That difference is your profit.

If you have not yet exited the position, when December expiration arrives, it's time to sell the IBM Jan 100 calls. 

a)
If IBM >100, you must buy back the Dec 100 call at the same time you
sell your Jan call.  In other words, you sell the calendar spread that
you bought earlier.

b) If IBM <100, the December calls expire worthless and you only have to sell the January calls.  WARNING:  If it's 10 minutes before the market closes and the stock is anywhere near the strike price (99.00 for example), don't assume that the calls will expire worthless.  It's a good idea to buy in those December calls for a few pennies, before selling the Jan calls.  Some brokers won't allow you to sell the Jan options if you are still short the Dec options.

c)
You are ready to sell the IBM Jan 100 calls. Several
factors are in play in determining the value of those calls. 

The second most important factor is the volatility environment.  If implied
volatility (IV) is low, the market price of the IBM Jan 100 call is
going to be less than when the IV is high.  Note: The IV of the
December call is far less important.  When expiration arrives, that IV
is zero – the option is worthless or worth parity (the amount by which
it's in the money).


Unless
you want to gamble (and I strongly advise against doing that), it's
usually best to exit the position by selling those January calls and
accepting the best available price. 

You may choose to keep
the calls and hedge them by creating a new IBM call spread,
but I suggest keeping things simple (especially for rookies) by
selling the calls.

Before
discussing additional aspects of a calendar spread, let's see how IV
plays a major role in determining your final profit or loss.

Example

If IBM closes at 100 on the 3rd Friday of December, then the IBM Jan 100 call will be worth various amounts, depending on IV.

IV
                       35
       40
          45
          50
        55

Call Value
    $4.02    
$4.57
     $5.12
     $5.67    
$6.22


The
point of this discussion is to be certain you are aware that when it
comes time to close the calendar spread, the profit (or loss) may be
significantly different than you anticipated when you made the opening trade. 

Calendar spreads earn the best profits when the stock expires very near the strike price.  But, if IV is low enough, even when the stock finishes right where you had hoped, you can still lose money on the trade if the price of the Jan 100 call is less than you paid for the calendar spread.  This is an unlikely occurrence, but not impossible.

Price at expiration

The final closing price (at expiration) of the
underlying stock affects the value of the spread and is usually the primary factor in determining whether the position earns or loses money. The further away from the strike price that the stock (or index) moves, the more unfavorable it is for the calendar spread owner.  That's why it's often a
good idea to exit the trade before expiration arrives.

Next time I'll provide examples to illustrate this point and then I'll discuss some of the
'Greeks' that are important when trading calendar spreads.  I want to keep the discussion as simple as possible for readers who are not yet familiar with the 'Greeks.'  

to be continued

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