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2. 2 Trading Calendar Spreads Steve Meizinger ISE Education

3. 3 Required Reading For the sake of simplicity, the examples that follow do not take into consideration commissions and other transaction fees, tax considerations, or margin requirements, which are factors that may significantly affect the economic consequences of a given strategy. An investor should review transaction costs, margin requirements and tax considerations with a broker and tax advisor before entering into any options strategy. Options involve risk and are not suitable for everyone. Prior to buying or selling an option, a person must receive a copy of CHARACTERISTICS AND RISKS OF STANDARDIZED OPTIONS. Copies have been provided for you today and may be obtained from your broker, one of the exchanges or The Options Clearing Corporation. A prospectus, which discusses the role of The Options Clearing Corporation, is also available, without charge, upon request at 1-888-OPTIONS or www.888options.com. Any strategies discussed, including examples using actual securities price data, are strictly for illustrative and educational purposes and are not to be construed as an endorsement, recommendation or solicitation to buy or sell securities.

4. 4 Calendar Spreads Definition »An option strategy involving the simultaneous purchase and sale of options of the same class and strike price but different expiration dates strike price expiration dates »The long calendar strategy involves trying to take advantage of the larger theta (amount of daily decay) shorter term options exhibit relative to longer term options

5. 5 What are Calendar Spreads? »A long calendar spread is the purchase of a longer dated option (call or put) and the sale of a shorter dated option (call or put) using the same underlying security »Debit Spread - More time normally costs more money »Different option expiries create differing thetas, theta is the amount an option decays per day

6. 6 All trades are based on some kind of forecast »Price - How far will the underlying move? »Time - How long will it take for the underlying price to move? »Volatility - What will the volatility of the option be when you close it out?

7. 7 Option Pricing »Options have value for two reasons: the cost of money and the variability of the underlying »Most standard models assume that the volatility is uniform throughout the term »What about earnings announcements and company developments and government rulings?

8. 8 One theory: “Sell expensive purchase cheap” »What is “cheap” or “expensive?” The answer depends on their relative value »Options theory assumes that all current news is reflected in the stock price »The expectations of news that will potentially drive the company’s stock price affects options pricing »The greater the potential for stock change, the greater the option premiums for the time periods affected

9. 9 “Sell expensive buy cheap” »Investors try to hedge their sales of “expensive” options by trying to purchase cheaper options »“Cheap” or “expensive” is in the eyes of the beholder, many options professionals will sort options by implied volatilities »Must keep in mind risk/reward tradeoffs »Calendar spreads is one strategy for selling expensive and buying cheaper options

10. 10 Implied volatility or historical, which one is right?

11. 11 Has anyone ever heard of the terms option smile and option skew? »The most important determinant in options pricing is volatility »Option prices rarely have the same implied volatilities for differing strikes within the same month or differing months »Often this is due to “fat tails skew,” the likelihood an extreme market move

12. 12 Vertical and Horizontal (time) Skew »Vertical skew refers to the different volatilities for the various strike prices (smile) »Horizontal skew refers to the different volatilities for the various months »Horizontal skew normally occurs when the marketplace expects an extraordinary event to occur in a particular month

13. 13 Extraordinary Events? »Earnings announcements for high visibility companies »Company developments, although these are often unplanned announcements »Government rulings- FDA, Federal Reserve, Justice Department

14. 14 How can we take advantage of horizontal skew? »If you have a neutral price forecast and the market “prices in” a more dramatic move you can purchase a calendar spread »Buy longer term “cheaper” option as measured by implied volatility and sell “more expensive” shorter term option »Goal is for spread to widen, hopefully the underlying stays at the strike price and does not move far away from strike price »Risk is that stock moves far away from strike price and spread will narrow

15. 15 Low risk strategy, not risk-free »If the underlying moves far away from strike price spread will narrow and a loss on the purchase of the spread will occur »Can be done with calls or puts although puts have early exercise possibility if stock drops dramatically

16. 16 Example Before Earnings »Earnings to be announced after the close, shorter term option has 12 days until expiration, longer term option has 34 days until it’s expiration »Sell front month 20 call for $1.85 and buy second month 20 call for $2.00. The implied volatilities are noticeable differently priced (about a 15 volatility point difference) »Stock was priced at 21.65 at the time, market was expecting a large move, the shorter term options relative expensiveness reflected this view

17. 17 Risk/Reward on Initial Trade Date

18. 18 The goal: The stock closes at the strike price at expiration

19. 19 Example after earnings without a dramatic change in the stock »Stock moves to $20.75 »Calendar trading at $.30, $0.85/$1.15, one day later »Spread widened due to the stock moving towards the strike price, the maximum profit for the spread

20. 20 Risk/Reward of (horizontal) Calendar Spread »If stock moves up dramatically or down dramatically our spread will narrow »Debit $.30, potential gain is approximately $0.75

21. 21 Time Passes »As time passes and stock remains at strike price, spread will normally increase in value »In this case with two days until expiration the spread is trading for $.45 ($.90-$.45) with stock trading at $20.40

22. 22 Price Variability Key to Pricing of a Calendar »This is lower risk alternative to selling a straddle »As with all of options trading, risk/reward are linked »If the stock remains relatively unchanged this strategy will take advantage of horizontal (time skew) as options will revert back to a more normal state after the announcement

23. 23 Five Month Calendar Instead? »Goal is that the stock is at or below the strike written, the short term option premium is received and hopefully another option can be sold in the future to reduce the longer term option’s cost

24. 24 Another Alternative »Buy five month calendar spread for $0.75 before earnings. One month option sold at $1.85, five month option purchased for $2.60 »One day after earnings were announced the calendar spread closed at $1.00

25. 25 Two Days Before Expiration »Front month is trading for $.45, stock is $20.40, Five month option is trading for $1.90, spread is $1.45

26. 26 At Expiration »The goal for the strategy is the stock closing at the strike price, a new short term option can be sold again.

27. 27 Calendar Spread Progression (stock remains unchanged) Calls 12 days left, prior to earnings announced 11 days left, post- earnings 2 days before expiry 1 month calendar $ 0.15 $ 0.30 $ 0.45 5 month calendar $ 0.75 $ 1.00 $ 1.45

28. 28 Calendar Hypothetical Price Progression (stock moves 20% lower) Calls 12 days left11 days left 2 days left 1 month calendar $ 0.15 $ 0.05 $ - 5 month calendar $ 0.75 $ 0.50 $ 0.40

29. 29 Calendar Hypothetical Price Progression (stock 20% higher) Calls12 days left11 days left2 days left 1 month calendar $ 0.15 $ 0.05 5 month calendar $ 0.75 $ 0.65 $ 0.60

30. 30 Summary »Calendar spreads are a low risk strategy for selling expensive options »As in all options strategies a forecast is required, in this case a neutral forecast »Looking for options skew will help identify calendar trading opportunities »Risk/reward must be balanced, if the stock moves dramatically the calendar will probably lose money

31. 31 Summary »Options skew normally becomes apparent when the market expects something other than the normal assumptions of the option pricing model »The terms “cheap” and “expensive” are relative terms, of course options can become even cheaper or more expensive depending on market conditions »Risk/reward tradeoffs must always be considered before entering any options transaction

32. 32 iseoptions.com