How do you take advantage of a near-term rally, which you expect will later falter?
The diagonal calendar spread
Options are an incredibly varied and flexible trading vehicle. You can not only trade up and down direction (using a vertical spread), as well as no direction at all, i.e., a sideways market (using an iron butterfly or a condor), you also can use options to trade a scenario in which one event will be followed by another—sort of a “first this, then that” type of thing. An ideal option strategy for actuating this market vision is the diagonal calendar, or time, spread.
Let’s say that you believe the market will continue to move higher through the end of the year, which is often the case because of portfolio window dressing (the so called Santa Claus rally) and then, instead of the usual New Year’s rally the market will sell off in January.
We’ll use the S&P 500 ETF (SPY) as our underlying value. It is very liquid and the options have a narrow bid/ask spread.
Here is a diagonal spread using puts. You sell an out-of-the-money put (strike B) in a near-term month and at the same time buy an out-of-the-money put in an expiration one month later (strike A).
The P&L graph for that strategy looks like this:
You can see that the profit and loss lines are not straight. This is because the farther dated option is still open after the near-term option expires. Straight lines indicate that all options have the same expiration.
Using real time (Oct. 29, 2014 at 10:00 CDT) prices you can do the following:
With SPY trading at 198.25 you sell the December 196 put at 3.75, and at the same time you buy the January 193 put at 3.80, for a 5¢ debit.
Assuming the December 196 put expires worthless you have the January 193 put for just 5¢. And, if it doesn’t your loss is capped because you are not net short options.
Let’s look at another scenario. Say that you think Facebook (FB) is being beaten down too much in the near-term (at this writing the stock is trading at $76.20, down nearly 6% on the day) and will rally later in the year.
So, let’s use a diagonal spread using calls to put this view into practice.
This entails selling a near term call (strike A) and buying a farther dated and further out of the money call (strike B).
You can sell the November 80 call (expiring in 23 days) at 97¢ and at the same time you buy the December 85 call at 77¢. You have put this spread on for a 20¢ credit. If the November 80 call goes out worthless you have the December 85 call for an effective price of –20¢. Better than free! You can sell the call or a sell a higher strike call against it. And, once again, if the November call does not expire worthless your potential loss is capped because you are not net short options. Although the trade does bear watching because you do not want to end up short FB stock and long a call (synthetic put), if your short leg looks like it may expire in-the-money you will need to unwind the position for a small loss.
A diagonal calendar, or time, spread is perhaps riskier than your plain vanilla horizontal (same strike) time spread, but the payoff is potentially greater.
To paraphrase that classic Dire Straits song, “The money for nothing and the options for free”!
Randall Liss is a veteran options trader. He helped found the European Options Exchange in Amsterdam (now part of Euronext), was a market-maker for that exchange and is co-founder of The Market-Makers Association. Since 2006 Liss has educated and mentored traders.