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An Option Strategy That Benefits From The Passage Of Time
by Jeff Wyman
Registered Options Principal and Host of the "Options Investing" radio show heard on NBC Affiliate
or "Let the Ice Cubes Melt"
Here's a strategy which, in my opinion, is one of the most versatile strategies you will ever see. It is called the calendar spread. There are many ways of executing this trade. But after much research and back-testing, I believe I've refined the strategy in a way that increases the odds of a successful trade. I do this trade on the S&P 100 index. The reasons for this are most compelling.
First, the S&P 100 index is comprised of a basket of 100 of the largest companies in the country. Therefore, we have 100 stocks to smooth out any bad news on any one stock. For example, Enron, the seventh largest company in the country collapsed. But the S&P100 index didn't collapse.
Second, the S&P 100, known as the OEX, is now offered as a European style option. For those of you who aren't familiar with this style of expiration, these are options that can only be exercised on expiration day. We can buy and sell these options all day long but no one can force us to do anything before we are good and ready to do it. This gives us a tremendous advantage.
And third, because we are trading a broad based cash-settled index, according to IRS rule 1256, 60% of all gains are treated as long term and 40% are treated as short term. Just a little more icing on the cake.
As you know, options are a wasting asset. Each day that passes they have one day less worth of life left in them. I like to look at them like ice cubes. Each day they melt away a little bit. The value of an option erodes with the passage of time, just like an ice cube melts. But all options don't erode at the same rate. Longer term options erode slower than shorter term options, just as a big block of ice melts at a much slower rate than a little ice cube. The good news is that it is possible to make money from this concept. Let me show you how.
Here is an example of the way I set up the calendar spread. I buy an option going out 180 days and I sell an option with the same strike price, going out 30 days. This is a trade that benefits by staying in a range. However, the range can be quite large at times. Usually, it is around 35 or 40 points. If I bought the 180 day option for $33, or $3300 per contract, and immediately sold the 30 day option against it for $10, I would have a cost basis in the trade of $23.
To find out how much a trade costs per day you would divide the cost by the number of days. This method is not 100% accurate for options, because the rate of erosion increases the closer an option gets to expiration. But, for the sake of illustrating the concept, this method will do. If we divide $33 by 180 we get roughly 18 cents a day. If we divide $10 by 30 we get roughly 33 cents per day. So the one we sold is melting at 33 cents a day and the one we own is only melting at 18 cents a day.
If the index, at expiration, finishes at the strike price of our spread, the 30 day option expires worthless and our 180 day option should have eroded about $5.40. Therefore, our 180 day option, which now has 150 days left, should be worth around $27.60 ($33 - $5.40 = $27.60). Our cost basis was $23 and we could sell it for $27.60. That would be 20% on our money in 30 days.
If the index finished outside of our range we would sell another 30 day option for next month and reduce our cost basis even further while creating the possibility of a another profitable month. If the index is very far away from our strike price we might not be able to collect much premium for selling an option. If it stayed that way for 6 months we could lose our investment in the trade. Could that happen? Yes. But what is the likelihood that in 6 months we wouldn't get any opportunity to reduce our cost basis somewhat?
I'm sure many of you have played the board game Monopoly. The strategy of the game is to buy property and build hotels so you can collect rent when someone lands on your property. I do the same thing with these spreads. I set up a portfolio of spreads at different strike prices so as the index swings back and forth it keeps passing through my hotels and I can close a trade successfully.
Let's recap some of the potential benefits to this strategy:
* We trade a basket of 100 of the largest companies in the world to smooth out bad news
* We have European style options so nobody can make us do anything before we're ready to do it
* We have a nice range for potential monthly profits
* We get many chances to reduce our cost basis
* We get very favorable tax treatment
I think you can see why this is my favorite strategy. Take a good close look at it. It may just become yours, too.
"Options are not suitable for all investors. Risk of loss of principal exists."
(EDITOR'S NOTE: Jeff is the host of the popular "Options Investing" radio show on NBC affiliate WDJA 850 am. He is President of Granite Financial Services in Boca Raton, Florida, where he specializes in option strategies and money management. His website, www.optionsbroker.net , is definitely worth a look. It's got lots of neat stuff, including options calculators and tutorials.)
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