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By: Money Morning
May 08, 2012 at 06:00 AM EDT
Options Trading: Three Ways to Win Big with a Bearish Calendar Spread
Think some of Wall Street's higher flyers look vulnerable to a broad market pullback? If so, they could be perfect candidates for a low-cost, low-risk options trading strategy that could pay off big time if we get another move like last Friday's 169-point Dow plunge. The strategy is called a "calendar put spread," and it works like this: You sell a slightly out-of-the-money put option with a strike price just below the current market price of the underlying stock - with a near-term expiration date. You then simultaneously buy a put option with the same strike price but with a more distant expiration date. The cost - and the maximum risk - is the difference between the two option premiums, referred to as the "debit" on the spread. But because the longer-term put you buy "covers" the shorter-term put you sell, there's no added margin requirement. It may sound complicated, but it's not once you understand how to employ this bearish options trading strategy. Options Trading Primer: A Potential 900% Gain in Six Weeks Here's how a bearish calendar spread might work with Exxon Mobil Corp. (NYSE: XOM ), which has held up better than many other oil stocks in recent weeks, closing last Friday at $84.57, barely $3.00 off its 52-week high: To continue reading, please click here...
Think some of Wall Street's higher flyers look vulnerable to a broad market pullback?
The strategy is called a "calendar put spread," and it works like this:
It may sound complicated, but it's not once you understand how to employ this bearish options trading strategy.
Options Trading Primer: A Potential 900% Gain in Six Weeks Here's how a bearish calendar spread might work with Exxon Mobil Corp. (NYSE: XOM), which has held up better than many other oil stocks in recent weeks, closing last Friday at $84.57, barely $3.00 off its 52-week high:
They include the following:
Profitable Outcome #1: Exxon Mobil continues to trade around $85 a share or higher through the expiration date (May 18) for the May $82.50 put you sold.
In that case the option you sold expires worthless and, though your June put will have lost some of its "time value," you should still have a modest profit of $25 or $30 - if you wanted to take it.
But, if you're still bearish, you wouldn't want to do that - you'll see why in just a second.
Profitable Outcome #2: XOM's price quickly drops several dollars, putting both of the $82.50 puts "in the money" at the May 18 expiration date. The May $82.50 put will thus have "intrinsic value," but all its time value will have been eroded.
By contrast, the June $82.50 put, which doesn't expire until June 15, will have both intrinsic value and substantial remaining time value - enough to again give you a modest profit should you close out the entire spread position.
Or, if you felt a further drop was still ahead, you could just buy back the May put shortly before the close on May 18 and continue to hold the June put.
Profitable Outcome #3: Exxon Mobil trades above $82.50 through May 18, when the May put you sold expires worthless. It then drops sharply before mid-June - say to $75 a share.
Had you held the June $82.50 put as described in No. 1 above - the optimum play with this strategy - it would be worth $7.50, or $750 for the full contract ($82.50 - $75.00 = $7.50 x 100 = $750).
Thus, your profit on your original $75 investment would be $675, or 900% - in just six weeks.
Had XOM dropped before May 18, and you held the June put as described in No. 2, your profit would also be substantial - the same $675 reduced by whatever you had to pay to buy back the May put at its expiration.
Worst Case Scenario: The only real losing scenario would have Exxon Mobil trading above $82.50 for the entire time prior to June 15. Both puts would expire worthless, and you'd forfeit the $75 you paid for the spread.
When to Use a Bearish Calendar Spread This strategy is most effective in choppy or topping markets when a downward break is anticipated, but the precise timing is in question. It gives you virtually the same potential as an outright put purchase (or short sale of the stock), but with much lower cost and risk.
Bearish calendar spreads also offer considerable flexibility.
For example, if the underlying stock is one of the 60 or so that offer "Weekly options" - as is Exxon Mobil - you could buy the longer-term put, then sell a whole series of shorter-term ones, harvesting a week's worth of time premium with each sale so long as the stock price stays above the strike price of your long put.
Depending on the stock's price movements, you could wind up with a totally "free" trade after two or three weeks - or even one with a guaranteed profit.
Similarly, if the near-term put you sell expires worthless and you're still bearish, but don't expect a really big move, you can convert the calendar spread into a simple bear spread by selling a put with a lower strike price than the one you own.
Any way you play it, the calendar put spread is a versatile strategy - one that puts time on your side while also offering the potential of a major payoff.
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Tags: options trading
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