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Using Calendar Spreads to Profit from a Bear Market - Part 2 |
by John Jagerson
Put calendar spreads are a great way to apply the benefits of covered options selling without having a bullish bias. This article will continue the discussion about put calendar spreads and what happens if the market trends against you before expiration. Before beginning this article you may want to learn more about the basic concepts of calendar spreads.
Click here for part one of this series on put calendar spreads.
The original trade setup included a long put position with a September 2009 expiration on the mini-sized S&P 500 index option ($XSP). The long position with a strike price of 65 had cost $6.60 per share or $660 per contract to open. The long term put established the trade's initial bearish bias.
A short put with a March 2009 expiration and a 65 strike price paid $1.30 per share or $130 per contract. When combined with the initial long position, the total first month debit or cost is $530 per spread. The short leg of the calendar spread is designed to reduce the amount of the spread cost attributable to time value thereby increasing the possibilities for profits.
Since initially setting up this trade the market has rallied. This is a great opportunity to look current option prices before March expiration and see how the calendar spread has protected the trade against some losses. The short leg of the trade is essentially a bullish hedge (selling a put is bullish) and will have offset some of the losses on the long side.
As this article is written the long leg of the spread has fallen in value to $4.90 per "share" or $490 per contract. That is a loss of $170 or 25% ($170 / $660 = 25%) on the long term put. However, the short leg has also lost value with a current quote of $0. If expiration were to occur today the option would expire completely worthless. That means that the short leg has profited $130 per contract so far.
If you offset the losses of $170 on the long put, with the $130 gain from the short put, the actual loss is $40 or 7% ($40 / $540 = 7%) per spread. As you can see, the short spread leg has helped to smooth volatility while the market trends against the initial forecast. At this point the spread could be closed by buying to close the short leg and selling to close the long leg.
However, for the purposes of this series of articles we will leave the spread alone and see how prices look at March expiration. The third article in this series will examine what the possible actions are at expiration and how the trade might be managed for the next month.
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