SHORT CALENDAR SPREAD
This strategy profits from the different characteristics of near and longer-term Call options. If the stock holds steady, the strategy suffers from time decay. If the underlying stock moves sharply up or down, both options will move toward their intrinsic value or zero, thus narrowing the difference between their values. If both options have the same strike price, the strategy will always receive a premium when initiating the position.
Outlook
Looking for either (1) a sharp move in either direction in the underlying stock during the life of the near-term option, or (2) a sharp move downward in implied volatility.
Motivation
Profit from sharp move in stock price.
Description
Long one Call option and short a second Call option with a more distant expiration. The strategy most commonly involves Calls with the same strike (horizontal spread), but can also be done with different strikes (diagonal spread).
Variation
The strategy described here involves two Calls with the same strike but a different expiration, i.e. a horizontal spread. A diagonal spread, involving two Calls with different strikes as well as expirations, would have a slightly different profit/loss profile. The basic concepts, however, would continue at apply.
Maximum loss
The maximum loss would occur should the underlying stock remain steady. If at the first expiration the stock is at the strike price of the expiring option, that option would expire worthless while the longer-term option would retain much of its time premium. In that situation, the loss would be the cost of buying back the longer-term option less the premium received when the position was initiated. If the near-term option expires worthless and the investor takes no action, the strategy becomes a Naked Call and there is no limit to the potential loss.
Maximum gain
The maximum gain would occur should the two options reach parity. This could happen if the underlying stock declined enough that both options became worthless, or if the stock rose enough that both options went deep in-the-money and traded at their intrinsic value. In either case, the gain would be the premium received when the position was initiated.
Profit and loss
The potential profit is limited to the extent the near-term option gains more quickly, or declines more slowly, in value than the longer-term option. During the life of the near-term option, the potential loss is a function of implied volatility, and a sharp spike higher could cause substantial losses. If the position is held beyond the expiration of the near-term option, however, the strategy becomes simply a Naked Call with no possibility of further profit and the potential for unlimited losses.
Break even
Since the options differ in their time to expiration, the level where the strategy breaks even is a function of the underlying stock price, implied volatility and rates of time decay.
Volatility
An increase in implied volatility, all other things equal, would have an extremely negative impact on this strategy. In general, longer-term options have a greater sensitivity to changes in market volatility, i.e. a higher vega. Be aware, however, that the near and far-term options could and probably will trade at different implied volatilities.
Time decay
The passage of time, all other things equal, would have a very negative impact on this strategy. In general, an option's rate of time decay increases as its expiration draws nearer.
Expiration risk
Slight. Expiration risk for this strategy would occur when the longer-term option expires. The greatest risk for this strategy emerges after the near-term expiration, when the strategy becomes a Naked Call. By comparison, the risk of being unexpectedly assigned when the longer-term option finally expires seems somewhat trivial.
Comments
The difference in time to expiration of these two Call options results in their having a different theta, delta and gamma. Obviously, the near-term Call suffers more from time decay, i.e. has a greater theta. Less intuitively, the near-term Call has a lower delta but a higher gamma (if the strike is at-the-money). This means that if the stock moves sharply higher, the near-term Call becomes much more sensitive to the stock price and its value approaches that of the more expensive longer-term Call.
How I intend to play it?
I plan to buy nifty 3400 Call April (LTP of 94) and sell 3400 Call May (LTP of 192). I plan to initiate this strategy on Thursday or maybe on Tuesday if I am not comfortable with the risk reward ratio. Problem is the gap ups and gap downs. In the past 10 trading sessions, we had 3 gaps and going by the present sentiments, Implied volatility becomes a big concern.
I solicit the comments of every member on this.
calculations
3100 CE May - 3100 CE April
192 94 = 98.00
No of lots = 4 each
Profit Target = 10,000 to 20,000
Investment
3400 april call buy = 4 x 50 x 94 = 18800
3400 may call sell = 4 x 50 x 3400 x 16% = 1,08,800
Premium = 4 x 50 x 192 = 38,400
Net investment = 108800 + 18800 - 38400 = 89,200
M2M losses provisional = 10,800
Total investment = 1,00,000
