| Using Calendar Spreads to Profit from a Bear Market - Part 3 |
Calendar spreads can be market neutral or slightly biased to the upside or downside. In the example we used in this series, the calendar spread was biased to the downside in at least two ways. Each of these biases become more important as expiration nears or the market moves with more volatility than the original forecast.  
Click here for the first article in this series on option calendar spreads. The first downside bias in this calendar spread because the strike prices involved were below the initial market price. At the time, this seemed prudent to account for the downward momentum in the market. The maximum gain in a calendar spread on a monthly basis, occurs if the market price equals the strike prices used at expiration. Therefore some downside movement would have put the market price closer to that maximum gain. The second bias can be seen by the use of puts in the calendar spread. Because a calendar spread is fairly neutral, calls would offer a similar risk profile as a spread but at expiration the short position expires and a long call or put is left. A bearish trader could leave the long put position active to take advantage of further downside momentum. At expiration there are three things that can be done to end, extend or modify the calendar strategy. 1. Unwind the trade by selling the long put The market has rallied since this case study started at the beginning of March 2009. The move has been enough to create a loss in the trade, however, the losses have been reduced by the premium from the short put. In that way, one of the strategic objectives have been achieved. At this point, if you thought the market was likely to continue to rally, exiting the position may be the best alternative. 2. Sell another 65 strike short term put In the original trade setup the 65 put with a March expiration was sold against the long 65 strike put with a September expiration. Although the market has moved, it is still possible to sell another short term 65 strike put for April's expiration. The extra income helps to reduce the basis and maximum loss that this trade could still be exposed to in the long term. Reselling another short term put extends the strategy and resets the price at which a maximum profit is achieved to $65. 3. Leave the long put uncovered As an analyst you may decide that the market is at a potential resistance level and the long put could become profitable again as prices move back down. Leaving the put uncovered provides for unlimited upside if the market falls significantly. This strategy would be superior to the second alternative of extending the spread if the market falls below the original strike price. All three alternatives are acceptable depending on market volatility and your own personal tolerance for risk. The take-away from this segment of the series on calendar spreads is to understand that time spreads require some decision making after the short term expiration. This allows for some flexibility and may offer cost savings over shorter term vertical spreads as the long side of the spread does not always have to be reentered or adjusted.
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3.25 Copyright (C) 2007 Alain Georgette / Copyright (C) 2006 Frantisek Hliva. All rights reserved." |
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