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Richard Croft
September 30, 2013
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Calendar spreads allow traders to take advantage of time value decay; the only mathematical certainty in the options market. Options have a limited life and the premium that one pays to buy or receives when selling is made up 1) time value and 2) intrinsic value.

Intrinsic value represents the in-the-money amount of the option’s premium. Out-of-the-money options have no intrinsic value and at expiration the only value implicit in any option contract is its intrinsic value.

The intrinsic value for a call option is calculated as the difference between the underlying security’s current price less the strike price of the call. For a put option, intrinsic value is the difference between the strike price of the put less the underlying stock’s current market price.

Time value is what a trader is willing to pay to create a leveraged position with limited risk. Time erodes as the option nears expiry and at expiration is zero. Complicating any discussion about option pricing is the fact that time does not erode in a straight line. In fact, time decay follows an exponential trajectory picking up speed as the option nears expiry.

To explain an exponential trajectory think about it these terms; an option with nine months to expiry would be expected to have approximately twice the time value of a three month contract; three being the square root of nine. Similarly, a four month contract would have about half the time value of a sixteen month option as four is the square root of sixteen.

The calendar spread involves the simultaneous purchase of a longer term call (or put) while selling a shorter term call (put) at the same strike price. The objective is to take advantage of this time decay trajectory, as the shorter term option will lose value at a more rapid pace than the longer term option.

Because the long option covers the short position, the risk in the calendar spread is limited to the difference in the cost of the two options. For example, at the time of writing, Suncor (TSX: SU) was trading at \$37.30. The Suncor January 38 calls were trading at \$1.30 while the Suncor November 38 calls were valued at 75 cents.

One could set up a calendar spread by purchasing the SU January 38 calls and selling the SU November 38 calls for a net debit of 55 cents. That debit is the maximum risk in the position. The maximum initial profit on this spread would occur if Suncor closed at exactly \$38 on the November expiration.

In that scenario, the November 38 call would expire worthless, while the at-the-money January 38 call with two months to expiry would likely be worth at least \$1.10 per share. Assuming you still liked the prospects for Suncor, you could hold the January 38 call and take advantage of further gains in the underlying stock.

Obviously, it is highly unlikely that Suncor would close at exactly \$38 on the November expiration. However, there is better than a 50 / 50 chance that Suncor will close at some price below \$38 at the November expiration.

The calendar spread is always a reasonable strategy given the certainty of time value erosion. However, this year there are factors that make the calendar spread unusually attractive! Think about the equity market’s smooth ride through September which is statistically the most difficult month for stocks.

October, on the other hand, is notorious for black swan events, and this year there are many such swans on the horizon. A US government shutdown being front and center, followed most likely by a rancid debt ceiling debate and the possibility of another Fed surprise. Not to mention a third quarter earnings parade which, by most accounts, will disappoint.

The calendar spread may well provide a path for traders to run the October gauntlet, and since the market will most likely survive, you could end up with a low cost leveraged play on stocks you want to own while defending that position against potential volatility during October and November.

Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group