TRADING FLOOR SECRETS: What is a Calendar Spread Worth at Expiration?
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April 14, 2006
You cannot evaluate a calendar spread (a.k.a time spread) properly without comparing the risk to the potential reward. Typically the maximum amount of risk associated with a calendar spread is what the spread was purchased for. Knowing what the spread is worth at its maximum profitability is a little trickier; however, this article will hopefully allow you to determine this on your own. Certainly there is no substitute for a good trading software package, but before software and the computer age traders had to approximate this information with little tricks of the trade. This article explains just such a trick, and the process is quite surprisingly simple.
Before proceeding with the approximation trick, you need to know the two rules associated with a calendar spread.
- First – time spreads are worth the most when the underlying is at the strike price, also known as at-the-money [ATM].
- Second – an ATM time spread is worth the most on the expiration of the expiring month.
If you purchased the Electronic Arts (ERTS) May 55 call and sold the April 55 call, the ideal place for the stock to close on April's expiration would be $55. Simple enough.
How to Estimate the Value
At the end of a particular expiration cycle you will want to obtain the option chain of every underlying you are interested in trading. As expiration is the 21st of April this month you will obtain the closing option prices of the May option chain for said stocks.
This can be done in many ways. The Chicago Board Options Exchange [CBOE.com] is an excellent source for obtaining this information. I do not care for computers so I prefer to go out of a newspaper. I guess the saying, “you can take the trader out of the pits, but you can't take the pits out of the trader” is an accurate one with me? Besides, my 5-year-old son Benjamin is not always around to operate the computer for me. I prefer to use the Investor's Business Daily out of habit, and I enjoy the motivational section and success stories it contains. It is a much better paper for traders than the competition. In addition, the IBD also has many more options listed than its counter, The Wall Street Journal.
I look at the closing price of the underlying stock and find the corresponding closest strike to find the ATM option for May prior to it's becoming the front month. Monday's paper, the 24th in this case, will have Friday's closing prices.
Whatever the value of the ATM call is for the new front month is what the time spread went out at. Provided that the stock was exactly ATM, suppose the front month call expired at $0, and the back month option closed at $2.00, you now know that the value of the calendar at expiration will be $2. Had you purchased the time spread at $0.60, you know that the most the spread can be worth at expiration (all other variables remaining constant) is $2.00.
Ideally, you hope that the stock and the strike price are exactly the same or you will have to use the option's delta to interpolate the value of the call (or put) had the stock closed exactly at strike (the maximum value). Suppose, for example, that ERTS closed at $54. The 55 call is the closest to the ATM strike so you will use that for the ATM strike, but you will also have to determine using delta what the option would be worth if it closed exactly at strike.
Since an ATM option is by definition a 50 delta option, meaning it will move $0.50 for every $1 move in the underlying, you can get a very close approximation of what the spread will be worth via interpolation. With ERTS at $54 we know both calls expired out-of-the-money (OTM). To determine what the calls would be worth if they expired ATM simply use delta to determine this. We know that if the stock advances $1, the ERTS May 55 call should increase in value approximately $0.50. Thus, if on expiration (with the stock at $54) the 55 call closed at $1.50, we know that it would be trading at about $2 with the stock at $55.
Bonus Trick
You can take this little trick one step further and determine your break even points by following this same principle throughout the range of strikes! Doing this procedure allows you to calculate how far off you can be on the stock price at expiration and still break even on the trade.
Before I proceed, please keep in mind that options are priced off of the normal distribution curve. Calls are not higher priced because the stock can go to infinity on the upside and only go to zero on the downside. So if you look at the value of the OTM calls and determine a time value, a close approximation will be true for puts that are about the same distance OTM (this is obviously not taking intrinsic value into consideration). The chart below will be used to explain the remainder of the article.
Suppose that ERTS has an option chain for the May options with exactly 1 month to go until expiration as follows:
The above table indicates that if the stock closes at $55 on April expiration, the May 60 strike call will be trading for $0.60. As the April option would have expired worthless, all that would remain of a long 60 strike calendar spread is a long 60 call, the calendar will close at $0.60. What does this mean?
The 60 strike calendar spread is $5 OTM (with the stock at $55) and is trading for $0.60. If you had purchased the 60 strike calendar anticipating an advance in the stock by expiration which never arrived, your trade would be worth $0.60 on expiration. Above I mentioned that we bought this spread for $0.60. Thus, even though we missed having the stock close at the desired strike on expiration, we still broke even. This tells us that we can miss the stock price by $5 on expiration and break even.
Had we purchased the 65 strike calendar for $0.60 when the stock was higher and the stock sold of to where it closed $10 away from being ATM, the spread would be worth $0.15 on expiration. Having bought the spread for a $0.60 debit and it now only trading for $0.15 indicates we would have lost $0.45. The same works in the opposite direction, meaning this is a +/- move phenomenon. In other words we could be wrong by a plus of minus $5 (for a total of a $10 range) and still have broken even.
I hope this helps clarify the calendar and conditions we dinosaur traders had to endure back in the stone age. Furthermore, this allows the trader to evaluate more accurately if he or she believes a trade is actually worth the risk considering the estimated payoff.
Thank you for taking the time to improve your option knowledge.
Scott Kramer
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site
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