How To Trade Trendless Stocks
SIMPLE OPTION STRATEGIES, aka SOS
In my first lesson we dealt with Vertical Spreads. The article began with a little ditty by the band The Police. The song “Message in a Bottle” seemed appropriate because of its lyrics which feature “I’m sending out an SOS and the title to my series of articles. Keeping up with tradition, today I’ll pay tribute to a Stones tune that I think we all know. Hopefully you’ll be able to find the relevance to this week’s lesson in its message. The song is “Time is on my side,” and you guessed it, today’s article is on Calendar/Time Spreads.
Calendar, or Time, Spreads are simply spreads wherein one purchases one calendar month and simultaneously sells another expiration month with the same strike, using the same type of option, either calls, or puts. For the purpose of this article, I will focus on Long Calendars. This means the further out month has been purchased. Because of the position structure, it is easier to explain and quantify in terms of associated risk and reward.
In initiating a Long Calendar, the intent is to capture, or collect, the front-month premium from the contract that is sold, thereby reducing the premium of the back month, which had been purchased at the same time. Huh???? It might sound complicated, but in reality it’s not. Now’s the time to think about the Rolling Stones and “Time is on my side, yes it is Time.” The goal of the Calendar plays homage to this message, as the spread increases in value as the stock bides its time before making the next up leg or move down. If the stock cooperates, we will offset any potential premium decay in our back-month option with larger gains from our near-term short position. This is called the widening of the spread, and since we are long the spread for a smaller initial debit, the result is a profit when unwinding the position.
“Timing is everything,” and Calendars aren’t an exception to this rule. To realize profitability, this type of position acknowledges the fact that technically, stocks make most of their large percentage moves in approximately 30% of the days traded (maybe a helpful reader knows the exact statistic). The Calendar spread attempts to take advantage of this technical condition by cashing in on the fact that most of the time stocks aren’t trending significantly one way or the other. Therefore, the spreader gets paid when the short premium collapses relative to the back-month contract, as time and relatively benign price action work in our favor.
The technical conditions that make for good Calendars are basing- or consolidation-type patterns. As the stock takes its time to build up a base from which it can make a solid percentage move, a Calendar spread stands to profit in what might otherwise be considered a “trendless” market. In fact, the market is trending, not for the stock players out there, but the more or less sideways price action is the perfect trend for our position. Eventually, as the basing process completes and the stock has “legs” for its next big move, we’ll have already made some cash in the process.
Calendars are also an effective way to take advantage of those impending big moves at a reduced cost. Let’s say for argument’s sake that you have a profit “on paper” and the technical conditions are now indicating a directional bias out of the trading range. Instead of taking the spread off, we can unwind our near-term short contract and stay long the outer month to participate in the move out of the base, that is if we have the right contract type on. Remember, we can use either calls or puts initially, as spreads with either type of option will perform in the same fashion. If your intentions are toward a certain directional bias after further base building, I would suggest using Calls for the potential upside breakout and Puts for a move down. Allowance for this type of action when initially setting up the Calendar will make (if you so choose) taking advantage of the move easier.
As noted earlier, the Long Calendar is easier to explain as the risk is defined by the premium paid for the spread, but money management/technical rules should still apply in order to minimize losses. Another risk associated with this spread is the near-term short contract. It’s nice to realize a profit, but until that contract is purchased back, the spread will carry potential directional risk. The difference between the contract being in-the-money or out-of-the-money at expiration will change your initial spread into either a Synthetic position (stock and the back contract) or simply a back-month call or put. The choice is yours; make sure for money management and risk purposes that you chose voluntarily by planning ahead with a proper strategy.
Let’s take a look at two examples of Calendar spreads that might represent good candidates for very different reasons. The first, shown below, is United Technologies (UTX).
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UTX is in a longer-term uptrend dating back to its September lows, but more recently has been in the process of correcting itself in a nice lateral basing pattern. With the use of some Fibonacci analysis (not shown), UTX has been trending sideways between the 38 and 62% retracement levels YTD high/low, and above the 38% level from the September lows to the March highs. This interpretation, along with the fact that UTX has traded in essentially a 3 point range might signal subsequent upside potential. One fact is certain, and that is UTX is in a range until further notice. It could break that range tomorrow, and a different setup might seem appropriate, but as of this writing on 6/17, it has the potential to qualify as a good Calendar spread.
With the stock trading around 69.5, the June/July 70 Call calendar could be initiated for 1.55 (Junes = .70 and July’s are at 2.25). June expiration is four days away, so if UTX continues to trade in its consolidation and below 70, the premium in June would represent a great way to get long the July 70 for a far cheaper price. Of course, the assumption here is that UTX does continue its meandering ways for a bit longer. Some might feel this is a big maybe, but this spread does have one more feature going for it to warrant consideration. Since we are in an expiration week at the 70 level strike, the odds increase that UTX will continue to trade around this price. This is not a proclamation of certainty, unlike death and taxes, but many times options expiration activity does indeed hold a stock close to its closest strike price, especially if open interest is significant. By the time this article is published, we’ll see if time was truly on our side with UTX.
Our next example is PeopleSoft (PSFT)
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Eyeballing the price action in PSFT for the last several months it’s pretty obvious that the only thing in common with UTX would be that I’m using it as an example of a Calendar spread. PSFT, like many of its Nasdaq (or is it Nas-duck?? Watch out below.) brethren, has seen better days. Most likely there is significant overhead in the form of anxious sellers waiting to get out of the stock, if PSFT is able to muster a reversal to the upside.
While this process has been wearing many investors and traders down, along with the stock price, technically speaking we may be encountering what’s known as a bottoming formation. Currently, it looks as though PSFT just finished testing its Sept./Oct. lows. Definitely not a perfect test, as there was one day in September when the stock went as low as 15.78, but given the methodical downtrend of the past two-and-a-half months, it could quite possibly be viewed as a legitimate test. I personally believe the downtrend, rather than a severe spike down, is one of the main reasons for thinking about PSFT as a time spread candidate. The current downtrend since early April has given many opportunities for new “investors” to become disgusted with the stock, and ready to supply overhead resistance, thereby reducing chances for a quick and substantial rally that would harm the Calendar spread in question. The scenario that we would like to see play itself out would be a slower-type rally that doesn’t jeopardize our spread by rallying too quickly through our strike. As the saying goes, “time heals all wounds,” and that’s exactly what we’re anticipating with PSFT.
Since my technical position on the stock is that a bottoming process is currently underway, a slightly out-of-the-money time spread could represent an excellent way to profit and keep one positioned for a longer-term move up. The Calendar that I feel best fits the technical condition of the stock (remember this is not a recommendation, but rather an educational example), based on my interpretation, is buying the July/Oct. 22.5 Call spread. As of 6/17, with the stock trading around 19.6, the spread goes for 1.85.
Here’s why I think this spread offers a nice play in PSFT, but remember, each of us must understand and adhere to our own trading methodology. This is my own analysis, with money management rules to further reduce risk. From the double bottom, my expectations are for a drawn-out rally because of the aforementioned shareholders and their supply of stock at higher levels. A subsequent rally of 50% using Fibonacci analysis from the April 2 high to the June 16 low would place the stock around the $23 level. The Calendar that I’m considering in this example is a three-month Calendar between expiring contracts, with five months until the back month expires. What makes this spread compelling is this: if my technical assessment resembles the ensuing stock action, I will have the opportunity to further reduce the cost of the back-month position by rolling my short contract into August, and then into short September premium. Remember that with this strategy I am currently looking to position myself long for as little cost as possible, while the bottom works itself out. Only time will tell if this little strategy pans out, but then again “Time Is On My Side”.