How to Trade Horizontal Option Spreads (Part 1)
10/21/2009 12:01 am EST
In a previous article, I utilized the quarterly options for my iron condor trade, and in this one, I will still stay on the topic of the quarterlies. It is my humble conviction that the quarterly options are under-utilized by option traders. The reason for my belief could be verified by looking at any of the open interest (O.I.) and volumes on the individual strike prices of either the calls or puts.
I do think that the Quarterlies are a good choice for trading if they are being sold. Due to the low O.I. and volume, the bid and ask spread on the individual strike prices tend to be wider than on the regular options, which expire on the third Friday of each month and get settled on the following Saturday prior to 11:59 am EST.
The wider spread usually means "juicier" premium. The more expensive quarterlies are, the more attractive they are to me for selling. I am all about being a premium seller, and the quarterlies offer me that possibility. Unlike regular options, the quarterlies are listed only four times per year, and they trade until the last trading day of those four months, namely, March, June, September, and December.
What I intend to do with the quarterly options is sell them after I have purchased something that is further away from the current June quarterly options. The common distinctions that certain brokerage firms are utilizing involve labeling the quarterly options in any of the three possible choices visually presented in Figure 1 below.
Now let us move on to the specific example in which I will be buying a longer-term option (July) and then turning around and selling the same strike price, but from the near month, in our case, the June quarterly option.
Once again, selling of the quarterly options can be done only four times per year and only on the specific products that have those options listed in their options chains. The ETFs (exchange traded funds) that track major indices such as the DIA, SPY, IWM, and QQQQ constantly list them, and hence, any of them could be selected.
In this example, I am focusing on the theory behind the horizontal option strategy rather than on the specific trade, therefore, there is not going to be technical analysis on this example. For instance, the underlying is trading at $36.88, and I could do the following transaction: Buy to open one OTM (out-of-the-money) contract of the July 38 call and then sell to open the June5 (quarterly) 38 call. The actual transaction might read as this: BTO + 1 July 38 call @ 2.68 and STO - 1 June 38 call @ 2.33.
As can be observed from the example above, the premium that is coming out of my pocket is 2.68, yet if I enter this horizontal trade simultaneously, instead of separately, then my premium of 2.33 from my sold quarterly call gets subtracted from 2.68, giving me the total cost of only 35 cents. Because each contract controls 100 shares, the amount of 35 cents is actually $35. Figure 2 below shows the specifics of each of these two contracts.
The longer-term option, which is the July 38 call, gives me the right (but not the obligation) to buy the underlying, which is currently trading at 36.88 for 38 times 100 shares. My right is in place until the expiry of that contract on the third Saturday of July. If the price stays below 38, them my July call will expire worthless. It is my current belief that by the third week of July, the underlying will be trading above 38.
However, I do not hold the same belief for the front month, or in this case, the end of June. I think that at the end of June, the underlying will close below the 38 level, which would make my June5 (quarterly) option worthless. Once that occurs, the premium of 2.33, which I have received from selling June5 (quarterly), will be mine and my obligation will cease to exist.
At that point in time, there is going to be some premium left in the July 38 call, mostly extrinsic (time) value, therefore, I could sell that option for whatever amount. I do think that there will be more premium in the July 38 call than just 35 cents, for the simple reason that the July option on July 1 will still have 17 days of time value left in it.
Once again, the total out-of-pocket cost of this trade was 35 cents. Whatever the premium of the July 35 call is on July 1 is pure profit when I close my existing option at that time. Usually, if the horizontal spread is placed simultaneously, then closing the long-term option after the expiry of the front-month option would be the normal scenario.
The second scenario could be simply holding on to the July 38 call and hoping it will increase in value. Hoping is normally not a good approach to trading, yet if the trader feels modestly bullish, then that is the choice that could be taken. However, the trader must be aware that the time decay is the greatest in the last two weeks prior to expiry. Holding long options during the last weeks before expiry is like holding an ice cube near the fireplace.
In conclusion, I have given an example of a horizontal trade which involved selling the front month (June quarterly) option after the long-term July option was purchased. Quarterly options are usually more expensive than regular options, which expire every month. Selling the quarterlies could be done only four times per year. I personally love to be the seller of overpriced premium and the quarterlies fit nicely in my criteria. Once again, have a good option trading experience and know your option strategies inside and out prior to trading them.
More tomorrow in Part 2…
By Josip Causic of OnlineTradingAcademy.com