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Last week's article titled "Going with the Flow" was all about, well, going with the flow. So this week, let's shift gears and go against the grain. To do so we will leave aside all talk of where the stock market or the bond market or the price of gold is likely headed next and dive into the realm of option trading strategies. Now, option traders reading that last sentence just got that warm and fuzzy feeling that comes with mentally preparing to dive into a favored topic. Non option traders, on the other hand, just felt the urge to hit the delete key. But wait! Remember for just one moment how much things have changed in the financial markets in recent years, and that the "tried and true" method of "buy and hold" - in the immortal words of whoever said it first - "ain't what it used to be." So maybe consider taking a few minutes now to "expand your horizons."

The unique thing about options is that they offer you opportunities not available to the average investor. The average investor buys a stock or a mutual fund and "hopes" it goes up in price. The intelligent speculator, however, is not locked into always being "long" and hoping price goes up (or going short and hoping price goes down). With options a trader can explore many "shades of gray." This article will detail one such example using an option trading strategy referred to as the calendar spread. Specifically, we are going to talk about an out-of-the-money (i.e., directional) calendar spread.

The Out-of-the-Money Calendar Spread

If you are unfamiliar with a calendar spread:

1. First note that every option has a preset expiration date.
2. Secondly note that each option has some "time premium" built into its price. This is essentially the price paid to the writer of an option to induce him or her to assume the risk of writing said option. In an option pricing model, the variable known as "implied volatility" tells you whether time premium is presently high, low, or somewhere in between.
3. Lastly, note that by option expiration all time premium vanishes and the option either expires worthless (if the stock fails to exceed the option's strike price) or equal to the amount by which the stock price exceed the option's strike price (referred to as "intrinsic value").

So a calendar spread simply involves buying one option of a farther out expiration month and simultaneously writing an option of a nearer expiration month. The heart of the trade revolves around the fact that the option with the closer expiration will experience time decay (the process whereby all of the time premium built into the price of the option goes to zero by the time of option expiration) at a much faster rate than the farther out option which will decay at a much slower rate (time decay accelerates as option expiration draws closer).

The "classic" calendar spread is done at-the-money (i.e., using options with a strike price close to the current stock price) to create a "neutral" trade (i.e., one where the trade makes money if the stock goes nowhere. However, it is possible to place a calendar spread using out-of-the-money options. But when and why would a trader do this?

1. When implied option volatility is low
2. When an up (or down) move is expected, but not with a high degree of confidence.

If a trader is confident that a given stock will rise sharply in price it typically makes more sense to simply buy a call option and thus enjoy the attendant unlimited profit potential. The problem here is that when buying calls time decay works against you. By buying an out-of-the-money calendar spread time decay works in your favor instead.

And why enter a calendar spread when time premium is low? Two reasons:

1. the greek term used to denote how much a call option will gain (or lose) in value if implied volatility rises (or declines) one percentage point. Since we are buying a longer term option we would ideally like to see implied volatility rise - which will cause time premium and thus the price of the option, to rise. While the shorter term option we sold will also increase somewhat due to vega, it will not gain nearly as much as the longer term option and will still be subject to more time decay than the longer term option.
2. If we enter a calendar spread when implied volatility is high and the implied volatility subsequently declines, we may experience something known as the volatility "crush", whereby our longer-term option loses a great deal of time premium as volatility declines. Since there is no defense for this - other than getting out of the trade as quickly as possible - it is best to avoid this possibility altogether.

HERSHEY EXAMPLE

So now let's look at an example of an out-of-the-money calendar spread. As always, please remember that this is only an example and not a recommendation. In Figure 1 you see a weekly chart for Hershey (ticker HSY). You can see that in recent months the stock has shot higher and has since been "coiling" or "compressing" in price. This is typically followed by a sharp move in one direction or the other. In Figure 1 you can also see that the stock recently completed a Wave 5 decline, which is bullish. So we are hoping for another thrust to the upside.

Figure 1 - Weekly chart for Hershey: A 5 Wave down move ended in March and prices recently spiked higher and are now consolidating

In Figure 2 you see the daily chart for HSY. On the daily chart the Elliot Wave count is looking for a Wave 5 advance, which also is bullish. Now HSY is not a stock prone to make huge percentage price moves. So while the Elliot Wave counts for both the daily and weekly are suggesting a move to higher prices, we might be wise to temper our expectations for a huge move.

Figure 2 - Daily chart for HSY: Support at $38 and (possibly) a Wave 5 up move in the offing?

As always, the other thing we want to do is minimize our downside risk. The most straightforward bullish play would be to buy 100 shares at about $39.05 a share, putting up $3,905 in the process. But let's consider a low dollar risk alternative that takes advantage of low implied volatility and time decay, while also giving us - at least in theory - unlimited profit potential.

The trade that we will consider appears in Figure 3 with the risk curves shown in Figure 4. With HSY trading at 39.05 we will buy ten January 2010 call options with a strike price of 45 and sell nine November 2009 call options, also with a strike price of 45. There are 53 days left until the November option expires. By buying one additional January call we make this trade "directional" as you will see in Figure 4.

Figure 3 - HSY calendar spread (out-of-the-money and directional)

As you can see in Figure 3, in this example we are entering the trade "at the market" - i.e., buying the January call at the ask price of 0.45 and selling the November call at the bid price of 0.25. We could just as easily put in a limit order and try to shave something off of that spread. In any event, if this trade were entered at the market in a ratio of 10 by 9, the maximum risk would be a whopping $225. Examples like this one are one of the reasons I sometimes shake my head when I hear someone talking about how "risky" option trading is. This example also illustrates how option strategies can afford traders the opportunity to "take a shot" for $225 rather than having to pony up $3,905 to buy the stock.

Figure 4 - Risk curves for HSY OTM (and directional) calendar spread

Other key things to note about this trade are:

• The breakeven price for the stock is 40.22, or just a little over one point above the current price of 39.05.
• Above 40.22 the profit potential is unlimited.
• If HSY were to retest the September 2008 high of 44.32, this would put it right into the high end of the profit potential range at expiration (the black line in the risk graph)
• If HSY is between 43 and 47 at the time of November option expiration this trade could generate a profit of $625 to $1,430 (which would occur in the unlikely event that HSY close at exactly 45 at November option expiration). If a trader was willing to risk $675 on a 30 by 27 trade (rather than a 10 by 9), these profit potential numbers would also be multiplied by three.

SUMMARY

It is entirely possible that the daily and weekly Elliott Wave counts displayed in Figures 1 and 2 will end up being wrong in portending a bullish move for HSY. And it is equally possible that the example trade we have illustrated will expire worthless and that the entire premium spent to enter the trade will be lost. To which I reply - somewhat defiantly - "so what?" The trade depicted here qualifies as a "speculation," not an investment. And there are some "truths" that one must accept when dealing in speculative activities. They are as follows (not an all-encompassing list and in no particular order):

1. You must do all that you can to put the odds as much in your favor as possible.
2. You must take the steps necessary to minimize your risk
3. If you make money you must not assume that you are a genius.
4. Losing sometimes is a part of speculation. Learn to live with it, and resolve to keep your losses small.

Whether or not this example trade will end up profitable or not is unknown. However, it does fulfill the "truths" listed above.

The trick is to apply these principles each and every time.

Jay Kaeppel
Staff Writer and Author of Seasonal Stock Market Trends
Optionetics.com ~ Your Options Education Site

Questions for Jay? Please visit "Ask the Traders" through the discussion board on the Optionetics.com home page.

NOTE: To learn more about Seasonal Stock Market Trends: The Definitive Guide to Calendar-Based Stock Market Investing, please click here.

Look for the interview with Jay Kaeppel in the upcoming November 2009 issue of Technical Analysis of Stocks and Commodities magazine.

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