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can be created when the strategist is neutral on the shares. Basically, in aneutral calendar spread, the trader wants the short-term option to decayat a faster rate than the long-term option. However, strategists can alsocreate both bullish and bearish calendar spreads depending on their out-look for the shares.
Calendar Spread Mechanics
Let’s  consider  an  example  of  the  calendar  spread  using  XYZ  at  $50  ashare in March. In this case, we expect the shares to stay at roughly thesame  levels  or  move  modestly  higher.  Consequently,  we  decide  to  pur-chase a LEAPS long-term option and offset some of the cost of that op-tion with the sale of a shorter-term option. In this case, we buy the XYZ60 LEAPS at $4 and sell an XYZ 60 call with two months of life remainingat $1. The cost of the trade is $300 [(4 – 1) × 100 = $300], which is alsothe maximum risk associated with this trade. The maximum proﬁt is un-limited  once  the  short-term  option  expires.  At  that  point,  the  trade  issimply a long call.
Prior  to  the  expiration  of  the  short  call,  the  maximum  proﬁt  andbreakeven  will  depend  on  a  number  of  factors  including  volatility,  thestock price, and the amount of time decay suffered by the long call. Basi-cally,  it  is  impossible  to  determine  how  much  value  the  long  call  willgain or lose during the life of the short option. Options trading software,such as the Optionetics.com Platinum site, can help give a better senseof the risk, rewards, and breakevens associated with any particular cal-endar spread. For now, sufﬁce it to say that the risk is limited to the netdebit.  In  addition,  time  decay  is  not  linear.  That  is,  an  option  with  30days until expiration will lose value more rapidly than an option with sixmonths until expiration. Calendar spreads attempt to take advantage ofthe  fact  that  short-term  options  suffer  time  decay  at  a  faster  rate  thanlong-term options.
Computing  breakeven  prices  for  complex  trades  requires  the  use  ofcomputer software. To understand why, let’s consider a bullish calendarspread. In this case, we are buying a longer-term call and selling a shorter-term call with the same strike price. The trade is placed for a debit andclosed for a credit. Ideally, the short-term call will expire worthless, butthe longer-term call will retain most or all of its value. In that case, we cansell another call or close the trade at a proﬁt. The breakeven price for thecalendar spread will depend on the value of the long call when the shortoption expires. The value of the long call will, in turn, depend on severalfactors. Say, for example, the stock price falls and the short call expiresworthless. The long-term option might still have value, but we don’t know
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exactly how much value because of changes in implied volatility and timedecay. To break even, the value of the long call when it is sold must beequal to the debit paid for the calendar spread. If the call is worth more,and the spread is closed when the short option expires, the trade yields aproﬁt. However, it is impossible to calculate the exact value of the longcall, and therefore, the breakeven when the short call expires. It is possi-ble  to  get  an  idea  or  rough  guess,  but  it  is  better  to  use  computer  soft-ware to plot the risk graph and see where the potential breakeven pointsmight be.
Exiting the Position
The exit strategy for the calendar spread is extremely important in de-termining  the  trade’s  success.  Speciﬁcally,  if  the  shares  remain  range-bound and the short call expires worthless, the strategist must make adecision: (1) to exit the position, (2) to sell another call, or (3) to roll upto another strike price. Generally, if the shares are stable as anticipated,the best approach is to sell another shorter-term option. In our example,the long call has 18 months until expiration and was purchased for $4. Acall  with  three  months  can  be  sold  for  $1.  If,  over  the  course  of  18months, calls with three months until expiration can be sold for $1 ﬁvetimes, the credit received from selling those calls totals $5. The cost ofthe long option is only $4. Therefore, the trade yields a $1 proﬁt on a $4investment,  or  25  percent  over  the  course  of  15  months.  Furthermore,after  15  months,  the  long  call,  which  has  been  fully  paid  for,  will  stillhave three months of life remaining and can offer upside rewards in caseXYZ marches higher.
Sometimes, however, it is not possible to sell another call. Instead,the share price jumps too high and the risk proﬁle associated with sell-ing another call is not attractive. In that case, the strategist might sim-ply  want  to  close  the  position  by  selling  the  long  call.  Or  anothercalendar spread can be established on the same shares by rolling up toa  higher  strike  price.  In  that  case,  the  strategist  closes  the  long  call,buys back another long call with a higher strike price, and then sells ashorter-term call with the same strike price. If the shares move againstthe strategist during the life of the short call, the best approach is prob-ably to exit the entire position once the short call has little time valueremaining.  If  the  shares  jump  higher  and  the  long  call  has  signiﬁcanttime value, it is better to close the position rather than face assignmentor buy back the short option. If assigned and forced to exercise the longoption  to  cover  the  assignment,  the  strategist  will  lose  the  time  valuestill left in the long contract.
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Calendar Spread
Strategy:  Sell  a  short-term  option  and  buy  a  long-term  option  using  ATMoptions with as small a net debit as possible (all calls or all puts). Calls canbe used for a more bullish bias and puts can be used for a more bearish bias.
Market Opportunity: Look for a range-bound market that is expected tostay between the breakeven points for an extended period of time.
Maximum Risk: Limited to the net debit paid. (Long premium – short pre-mium) × 100.
Maximum Proﬁt: Limited. Use software for accurate calculation.
Breakeven: Use software for accurate calculation.
Margin: Amount subject to broker’s discretion.
Calendar Spread Case Study
Shares  of  Johnson  &  Johnson  (JNJ)  are  trading  for  $51.75  during  themonth of February and the strategist expects the shares to make a movehigher. A bullish calendar spread is created by purchasing a JNJ January2005 60 call for $4 and selling an April 2003 60 call for $1. The trade costs$300:  (4  –  1)  × 100  =  $300.  Therefore,  the  initial  debit  in  the  account  isequal  to  $300.  The  debit  is  also  the  maximum  risk  associated  with  thistrade. As the price of the shares rises, the trade makes money.
As we can see from the risk graph in Figure 10.7, the maximum proﬁtoccurs  when  the  shares  reach  $60  at  April  expiration  and  is  equal  toroughly $570. At that point, the short call expires worthless, but the long
Calendar Spread Case Study
Market  Opportunity: JNJ  is  expected  to  trade  moderately  higher.  Withshares near $51.75 in February, the strategist sells an April 60 call for $1and buys a January 2005 60 call for $4.Maximum Risk: Limited to the net debit. In this case, $300: (4 – 1) × 100.
Maximum Proﬁt: Limited due to the fact that the short call is subject toassignment risk if shares rise above $60.
Upside  Breakeven: Use  options  software  to  calculate.  In  this  case,roughly $47.
Downside  Breakeven: Use  options  software  to  calculate.  In  this  case,same as upside breakeven.
Margin: Theoretically,  zero.  The  short  call  is  covered  by  the  long  call.Check with your broker.
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Today: 63 days left 42 days left 21 days leftExpiration
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FIGURE 10.7 JNJ Calendar Spread (Source: Optionetics Platinum © 2004)
call has appreciated in value and can be sold at a proﬁt. If the strategistelects to hold the long call instead, another calendar spread can be estab-lished by selling a shorter-term call. At that point, the risk curve will prob-ably  look  different.  The  downside  breakeven  is  46.80.  Below  that,  thetrade begins to lose money. An options trading software program like Plat-inum can be used to compute the maximum gain and the breakevens.
In this case study, the stock did indeed move in the desired direction.By April expiration, shares of JNJ fetched $55.35 a share. At that point, theshort call would expire worthless and the strategist would keep the entirepremium received for selling the April 60 call. Meanwhile, the January 60call  has  not  only  retained  all  of  its  value,  but  it  is  currently  offered  for$5.10. Therefore, the strategist’s earnings are $210 of proﬁt per spread ($1received for the premium and $1.10 proﬁt for the appreciation in the Janu-ary 60 call), for a ﬁve-month 70 percent gain. On the other hand, the strate-gist could also hold the long call and sell another short-term call with thesame or higher strike price. If the strategist chooses to sell a call with ahigher strike price, the position becomes a diagonal spread, which is alsoour next subject of discussion.
VOLATILITY SKEWS REVISITED
As  we  have  seen,  calendar  spreads  are  trades  that  involve  the  purchaseand sale of options on the same shares, with the same strike price, but dif-ferent expiration dates. One thing to look for when searching for calendar
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spreads is a volatility skew. A volatility skew is created when one or moreoptions  have  a  seeable  difference  in  implied  volatility  (IV).  Impliedvolatility, as mentioned in Chapter 9, is a factor that contributes to an op-tion’s price. All else being equal, an option with high IV is more expensivethan an option with low IV. In addition, two options on the same underly-ing  asset  can  sometimes  have  dramatically  different  levels  of  volatility.When  this  happens,  it  is  known  as  volatility  skew.  Looking  at  variousquotes  of  options  and  looking  at  each  option’s  IV  will  reveal  potentialvolatility skews.
As previously mentioned, there are two types of volatility skews pre-sent  in  today’s  markets:  volatility  price  skews  and  volatility  time  skews.Volatility  price  skews  exist  when  two  options  with  the  same  expirationdate have very different levels of implied volatility. For example, if XYZ istrading at $50, the XYZ March 55 call has an implied volatility of 80 per-cent and the XYZ March 60 call has implied volatility of only 40 percent.Sometimes this happens when there is strong demand for short-term at-the-money  or  near-the-money  call  (due  to  takeover  rumors,  an  earningsreport, management shake-up, etc.). In that case, the 55 calls have becomemuch more expensive (higher IV) than the 60 calls.
Calendar spreads can be used to take advantage of the other type ofvolatility skew: time skews. This type of skew exists when two options onthe same underlying asset with the same strike prices have different levelsof implied volatility. For example, in January, the XYZ April 60 call has im-plied  volatility  of  80  percent  and  the  XYZ  December  60  call  has  impliedvolatility of only 40 percent. In that case, the short-term option is more ex-pensive  relative  to  the  long-term  call  and  the  calendar  spread  becomesmore  appealing  (although  the  premium  will  still  be  greater  for  the  longcall  because  there  will  be  less  time  value  in  the  short-term  option).  Theidea is for the strategist to get more premiums for selling the option withthe higher IV than he or she is paying for the option with the low IV.
DIAGONAL SPREAD
There  are  a  signiﬁcant  number  of  different  ways  to  structure  diagonalspreads.  Diagonal  spreads  include  two  options  with  different  expirationdates and different strike prices. For example, buying a longer-term calloption and selling a shorter-term call option with a higher strike price canbe a way of betting on a rise in the price of the shares. The idea would befor the shares to rise and cause the long-term option to increase in value.The short-term call option, which is sold to offset the cost of the long-termoption, will also increase in value. But if the shares stay below the short
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strike price, the short option expires worthless. In this type of trade, thelonger-term option should have some intrinsic or real value, but the optionsold  should  have  only  about  30  days  or  so  to  expiration  and  consist  ofnothing but time value. This strategy proﬁts if the shares make a gradualrise.  Similar  diagonal  spreads  can  be  structured  with  puts  and  generateproﬁts if the shares fall.
Diagonal Spread Example
Diagonal  spreads  are  a  common  way  of  taking  advantage  of  volatilityskews. Let’s consider an example to see how. The rumor mill is churningand there is talk that XYZ is going to be the subject of a hostile takeover.With shares trading at $50 a share, the rumor is that XYZ will be purchasedfor $60 a share. At this point, you have done a lot of research on XYZ andyou believe that the rumor is bogus. Furthermore, you notice that the talkhas  created  a  time  volatility  skew  between  the  short-term  and  the  long-term options. In this case, the March 55 call has seen a jump in impliedvolatility  to  100  percent  and  trades  for  $1.50.  Meanwhile,  the  Decembercontract  has  seen  no  change  in  IV  and  the  December  50  call  currentlytrades for $6.50.
To  take  advantage  of  this  skew,  the  strategist  sets  up  a  diagonalspread by purchasing the December 50 call and selling the March 55 call.The idea is for the short call to lose value due to time decay and a drop inimplied volatility. Meanwhile, the long-term option will retain most of itsvalue. The cost of the trade is $5 a contract or $500: (6.50 – 1.50) × 100.This is the maximum risk associated with the trade.
There  are  no  hard-and-fast  rules  for  computing  breakevens  and  maxi-mum proﬁts for diagonal spreads. In our example, the ideal scenario wouldbe for the short option to lose value much faster than the long option due toboth falling IV and time decay. However, the term diagonal spread refers toany  trade  that  combines  different  strike  prices  and  different  expirationdates. Therefore, the potential combinations are vast. However, it is possibleto compute the breakevens, risks, and rewards for any trade using optionstrading software like the one available at Optionetics.com Platinum site.
Exiting the Position
The same principles that were discussed with respect to calendar spreadsapply to diagonal spreads. If the shares move dramatically higher, the shortoption has a greater chance of assignment when it moves in-the-money andtime decay diminishes to a quarter of a point or less. If the long call has sig-niﬁcant time value, it is better to close the position than face assignment. Ifassigned and forced to exercise the long option, the strategist will lose the
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time value still left in the long contract. If the short option expires as antic-ipated, the strategist can close the position, roll up to a higher strike price,or simply hold on to the long call.
In the previous example, a diagonal spread was designed to take ad-vantage of a volatility skew. Once the skew has disappeared and the ob-jective is achieved the strategist can exit the position by selling the longcall and buying back the short call. However, it generally takes a relativelylarge volatility skew in order to proﬁt from changes in implied volatilityalone. Therefore, strategists generally use time decay to their advantageas  well,  which,  as  we  saw  earlier,  impacts  shorter-term  options  to  agreater degree than longer-term options.
In the example, the idea was to take in the expensive (high IV) premiumof the short option and beneﬁt from time decay. As a result, once the shortoption expires, there is no reason to keep the long option. Thus, selling anidentical call can close the position. If the shares fall sharply, the trade willlose value and the strategist wants to begin thinking about mitigating losses.A sharp move higher could result in assignment on the short call as expira-tion  approaches.  Again,  it  is  better  to  close  the  position  than  face  assign-ment because the long option will still have considerable time value, whichwould be lost if the long call is exercised to cover the short call.
Breakeven Conundrums
While the risk to the diagonal spread is easy to compute because it is lim-ited to the net debit paid, and the reward is known in advance because itis unlimited after the short-term option expires, the breakeven point is abit  more  difﬁcult  to  calculate.  Often,  traders  ﬁrst  look  at  the  breakevenprice when the short-term option expires. However, at that point in time,the longer-term option will probably still have value. In addition, the valueof that long option will be difﬁcult to predict ahead of time due to changesin implied volatility and the impact of time decay.
For example, assume we set up a diagonal spread on XYZ when it istrading for $53 a share. We buy a long-term call option with a strike priceof 60 for $3 and sell a shorter-term call with a strike price of 55 for $1. Thenet debit is $200. Now, let’s assume that at the ﬁrst expiration the stock istrading for $54.75 and the short-term option expires worthless. How muchis the longer-term option worth, and what is the breakeven? It is difﬁcultto  predict  what  the  longer-term  option  will  be  worth  because  of  the  im-pact of time decay and changes in implied volatility. So, it is impossible toknow  the  breakeven  when  the  short-term  option  expires  because  it  willalso  depend  on  the  future  value  of  the  longer-term  option.  If  the  longer-term option has appreciated enough to cover the cost of the debit whenthe short-term option expires, the trade breaks even.
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Diagonal Spread
Strategy: Sell a short-term option and buy a long-term option with differ-ent strikes and as small a net debit as possible (use all calls or all puts).
• A bullish diagonal spread employs a long call with a distant expira-tion and a lower strike price, along with a short call with a closer expi-ration date and higher strike price.
• A bearish diagonal spread combines a long put with a distant expi-ration date and a higher strike price along with a short put with a closerexpiration date and lower strike price.
Market Opportunity: Look for a range-bound market exhibiting a timevolatility skew that is expected to stay between the breakeven points foran extended period of time.
Maximum Risk: Limited to the net debit paid. (Long premium – short pre-mium) × 100.
Maximum  Proﬁt/Upside  Breakeven/Downside  Breakeven: Use options  software  for  accurate  calculation,  such  as  the  Platinum  site  atOptionetics.com.
After the short-term option expires, the breakeven shifts to the expi-ration  of  the  longer-term  option.  In  this  case,  the  breakeven  price  be-comes  the  debit  plus  the  strike  price,  or  $62  a  share.  However,  thebreakeven  will  change  again  if  we  take  follow-up  action  like  selling  an-other short-term call option.
In sum, it is difﬁcult to know exactly what the breakeven stock pricewill be for the diagonal or calendar spread because we are dealing withoptions  with  different  expiration  dates.  In  these  situations,  the  best  ap-proach is to use options-trading software to get a general idea. However,even software is not perfect because it can’t predict future changes in anoption’s future implied volatility. The best we can do is to calculate an ap-proximate breakeven and then plan our exit strategies accordingly.
Diagonal Spread Case Study
For  the  diagonal  spread  case  study,  let’s  consider  Johnson  &  Johnson(JNJ) trading for $51.75 a share in early February 2003. The strategist setsup a diagonal spread by purchasing a January 2005 50 call for $6.50 andselling the March 2003 55 call for $1.50. Again, there is time volatility skewwhen purchasing these contracts and the long call has lower IV comparedto the short call. This type of time volatility skew is a favorable character-istic when setting up this type of diagonal spread.
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The risk, proﬁt, and breakevens for this trade are relatively straight-forward. The cost of the trade is $500 and is equal to the premium of thelong call minus the short call times 100: [(6.50 – 1.50) × 100]. The debit isalso  the  maximum  risk  associated  with  this  trade.  Proﬁts  arise  if  theshares move higher. The maximum proﬁt during the life of the short callequals $374.45. After the short call expires, the position is no longer a di-agonal spread. It is simply a long call. At that point, the strategist can sell,exercise, or hold the long call.
The risk curve of the diagonal spread is plotted in Figure 10.8. It is simi-lar to the calendar spread. In both cases, the strategist wants the share priceto move higher, but not rise above the strike price of the short call. A movelower will result in losses. If the stock rises and equals $55 a share at theMarch  expiration,  the  short  call  will  expire  worthless.  The  strategist  willkeep the premium received from selling the short call and will have a proﬁtfrom an increase in the value of the call. At that point, he or she can sell, ex-ercise, or hold the long call. If the trader elects to hold the long call, anotherdiagonal spread can be established by selling another shorter-term call.
So,  what  happened  with  our  JNJ  calendar  spread?  Shortly  after  thetrade was initiated, shares rallied sharply and, in the week before expira-tion, the stock was well above the March 55 strike price. At that point, wewould be forced into follow-up action because assignment was all but as-sured. For example, the week just before expiration, the stock was mak-ing its move above $55 a share. Seeing this, the strategist would probably
Today: 35 days left 23 days left 11 days leftExpiration
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FIGURE 10.8 JNJ Diagonal Spread (Source: Optionetics Platinum © 2004)
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want to buy the short-term call to close because assignment would forcehim or her either to buy the stock in the market for more than $55 a shareand sell it at the strike price or cover with the long call, which still has asigniﬁcant amount of time value.
So,  facing  the  risk  of  assignment,  the  position  is  closed  when  thestock moves toward the strike price of the short call. The Friday beforeexpiration, the January 2004 50 call was quoted for $8.50 bid. Therefore,the strategist would book a $2 proﬁt on that side of the trade. At the sametime, he or she would want to buy to close the short March 55 call, whichwas  offered  for  $1.  That  side  of  the  trade  would  yield  a  50-cent  proﬁt.Therefore, taken together, the strategist makes $250 on a $500 investment.Time decay has indeed worked in this trade’s favor.
The  reason  I  like  trading  diagonal  spreads  is  that  they  lend  them-selves  to  numerous  position  adjustments  during  the  trade  process.  Forexample, say we initiate a diagonal calendar spread on stock XYZ by pur-chasing a longer-term ITM call option and writing a shorter-term slightlyOTM call option. This position can be put on at a lower cost than the tra-ditional  covered  call  and  with  a  subsequent  lower  risk.  It  also  has  ahigher-percentage return than a covered call but still proﬁts from time de-cay. However, the real advantage of the position in my view is its inherentﬂexibility.  Consider  just  some  of  the  adjustments  afforded  the  optionstrader with the diagonal spread position:
• XYZ is below the strike price that we initially sold: Let it expireworthless and realize the short-term call premium as a proﬁt. We canthen exit the long position, or sell another short-term call for the nextmonth out.
• XYZ is near or above the short strike price by the expirationdate: Buy  the  short  option  back  and  sell  back  the  long  position  toclose the trade, or sell the next month calls of the same strike or evena higher strike if the underlying stock has an upward directional bias.• XYZ  is  deep  in-the-money: Exit the entire position and rebracket
the diagonal spread at the new trading range.
In addition, we can convert from a diagonal spread to a horizontal ifmore than 60 days are still left until expiration. If we are going into the ﬁ-nal 30 days of the long position we can transform this position into a verti-cal  spread.  Even  though  our  XYZ  example  was  created  using  calls,  thetrader can also construct this position using put options.
These  are  just  a  handful  of  adjustments  afforded  the  options  traderwhen managing a diagonal spread. I encourage you to test and paper tradethese types of positions. The adjustment possibilities are virtually endlessand for my money that makes for a terriﬁc options strategy.
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Diagonal Spread Case Study
Strategy: With JNJ trading for $51.75 in February, set up a bullish diago-nal spread by selling a