*This article was originally published in The Option Strategist Newsletter Volume 11, No. 9 on May 16, 2002. *

Bear markets are marked by sharp, but often short-lived rallies that bring stocks back to resistance levels. The huge rally on Wednesday of this week may be another one of those (for more thoughts on this subject, see the Market Commentary on page 5). Such a rally often finds stocks rallying back to levels from which they had recently broken down. Even if a bull market starts, many stocks will rally up to a significant resistance level and then pause.

Many traders get overly aggressive when considering such scenarios and risk too much money – hoping for a rally to bring the stock up to resistance levels in a bear market. One strategy that might work better for such movements is an out-of-the-money calendar spread. While the entire debit is at risk, there is usually a relatively small initial investment. In this article, we’ll also discuss some ways to use mathematics to try to put the odds in our favor for such a strategy.

The basic concept behind an out-of-the-money calendar spread is that one invests a relatively small amount of money, in hopes that the stock will make a move to get it to the striking price of the spread at some time before expiration. If such a move occurs, the spread should widen out – often by a large percentage. In fact, the closer to expiration it is when the stock makes this move, the bigger the rewards will be.

Let’s look at an example:

XYZ: 40

Buy the August 50 call @ 2 Sell the June 50 call @ 1

The stock is at 40, and the striking price is at 50. Since this is a call calendar spread, that means both calls are out of- the-money to begin with. The initial debit is 1 point, plus commissions, and that is the risk of the spread. So even though the dollar risk is small, the percentage risk is still 100%. Accordingly, one should moderate his risk as we normally recommend, by not risking more than 3% of one’s trading account in any one particular position.

The above profit graph clearly shows that, if the stock moves up to 50, there will be a profit – even if the move happens almost immediately. Of course, the profit “in 7 days” is small and might not exceed commission expenses or the bid-offer price of the actual spread. However, the theory is that the spread will widen in these cases.

Once the position is in place, there are only a few follow-up moves that need be made. One usually removes part, if not all, of the spread if the stock moves to the striking price. On the other hand, there is not normally much that needs to be done in terms of risk control. If the stock falls, both calls will tend to be fairly worthless, and the maximum loss will be realized – although if the nearterm call expires worthless, the spreader will then own the longer-term call outright. If there is a bid for that longerterm call, he needs to make a decision as to whether to sell it then and recoup something or to hold it in case the stock rallies later on.

To scan for spreads such as these, one would look for stocks that have broken down (perhaps sharply) below major support levels. That support then becomes resistance. The philosophy is that even an oversold rally may bring the stock back to such resistance levels.

Another criteria that the calendar spreader should look for is relatively low implied volatility in the options when he buys the spread, for an increase in implied volatility is beneficial to a calendar spreader.

With the aid of a sophisticated probability calculator, such as our Probability Calculator 2000 (PC 2000), one can get a better “handle” on how likely such a move is. We can ask PC 2000 questions such as “What is the probability of the stock hitting the strike in 7 days?” or “30 days?” or “at expiration?”

To see how this might work, let’s use the same example and assume that the stock has a historic volatility of 50%. The PC 2000 results are as follows:

Trading Days Prob ever hits 50 in n Days 30 23% 22 16% 5 1%

So the probability that the stock ever trades at 50 in a week (5 trading days) is only 1%. The probability that it trades at 50 sometime before expiration is 23%. Finally, the probability that it trades at 50 within the first three weeks is 16%.

These are not independent probabilities, so we can’t just subtract them to determine the answers to questions such as “What is the probability that the stock trades at 50 during the last eight trading days before expiration?” It might seem that we could just subtract the two probabilities (23% minus 16%) and arrive at an answer of 7%. However, that estimate is too low. For example, suppose the stock were to rise to 50 in the first two weeks and then just stay there for the rest of the time. That event would not be accounted for in the 7% figure. Nor would the case where the stock rose to 60 and then came back to 50 during the last eight trading days. So we re-programmed the Monte Carlo simulation in the PC 2000 program and asked it the above question, specifically. The answer is that we can expect the stock to trade at 50 during the last eight trading days, 12.6% of the time.

This is an important piece of information for a calendar spreader – even for at-the-money calendars. For example, if we use the above example with a calendar at a striking price of 40 (i.e., if the stock is 40 to begin with and the striking price of the calendar spread is 40), what is the probability that the stock trades at 40 during the last eight days of life of the spread? It’s 25%, according to the Monte Carlo simulation. Not exactly intuitive, is it?

We are working this probability – and other similar ones – into our calendar spread analyses that will be available soon on The Strategy Zone. As far as I know, this sort of analysis is unique for calendar spreaders, and we hope that it will be able to spot spreads with exceptional profit-making opportunities – or at least point out realistic evaluations for this popular strategy.

*This article was originally published in The Option Strategist Newsletter Volume 11, No. 9 on May 16, 2002. *

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