Factors change, as witnessed this week with the spike in volatility. In recognition of that, it is important to understand how changes in say, volatility, affect the strategy. Generally volatility has a greater impact on shorter term options. The reason is that volatility is not linear. A stock is just as likely to move sharply up or down on any given day or week, as it is to make that move over a month. Point is, a change in the value of the underlying stock can occur at any point. What this means is that a spike in volatility negatively impacts a calendar spread. It will cause the shorter term option to rise more dramatically than the longer term option.

In addition, significant moves in the underlying security will also negatively impact this spread. If ABX, which was the example I cited last week, were to rise above $43 or fall below $37, the spread will narrow, and cause a small loss. But in all cases – aside from early assignment - the risk is limited. Given that, there should be opportunities to the position with a profit some point prior to expiration of the short term option.

The ideal calendar spread is one where you use options on stocks with above average volatility –gold and oil stocks fit the criteria – and that will likely remain in a trading range between now and the expiry of the shorter term option.

Having selected stocks that meet that criteria, look at the implement the calendar spread using calls that are slightly out-of-the-money.

ShareThis

The strategy involves the purchase of a longer term call (or put) option coupled with a simultaneous sale of a shorter term call (or put) option. Both options having the same strike price.

Gold stocks make interesting case studies in the current market environment. That is, if you believe that gold will trade in a range between US$1,000 and US$1,200 over the next six months.

With Barrick Gold (symbol ABX) trading at $39.59 per share, a calendar call spread might involve the purchase of the ABX April 40 calls at $3.75 ($375 per contract) combined with the sale of the ABX Nov 40 calls at $1.15 ($115 per contract). You are long and short calls with the same strike price, but different expiration months.

For margin purposes, the long call covers the short call. As well, a calendar spread is a debit spread, which with our ABX example means a debit of $2.60 ($260 per spread). Theoretically, the most you can lose from a calendar spread is the net debit.

I say theoretical, because you could be assigned early on the short option if the counterparty was say, interested in collecting a dividend. In that position, you would be required to buy back the shares – ex dividend - in order to meet the assignment notice. However, with stocks like ABX that do not pay a significant dividend, the risk of early assignment is relatively low.

The key to a calendar spread is the eroding time value. The option pricing formula calculates time value erosion with the “theta” derivative (often referred to as “Greeks”) within the formula. For more information on option pricing, see the MX Option Calculator at http://www.m-x.ca/accueil_en.php then click Options Calculator on the left side of the page.

When I input the following ABX data into the calculator on October 25th - stock price $39.59, strike price $40, volatility 31%, November 2009 expiration, 1% interest rate assumption, $0 dividend and 12/12/09 for the dividend date - the theoretical call price is $1.15.

The ABX November Calls’ theta is -9.124, which is an annualized number. Divide that number by 365 and we get -.0249, which means that the November 40 call should decline in value by 2.5 cents per day, assuming all other factors remain the same and the stock remains stagnant.

If we apply the same calculation to the ABX April 40 call theta comes in at -3.7, which translates into a -1.01 cent per day loss associated with time value. In other words the April call is losing time value at 40% of the rate of the short term call.

Mathematical Certainty
What makes the calendar spread interesting is that its success or failure is determined by a set of mathematical constants. We know with certainty that time value will decline to zero at expiration. We know that time value decays more quickly the closer the option is to expiration.

If ABX remains unchanged between now and the November expiration date, this position will most likely generate a profit. Why? Because at the November expiration, the April options will still have 161 days to expiry. If the stock is at $39.59, the April 40 calls should be worth at least $3.15 ($315 per contract). Since the initial debit was $2.60, a $3.15 value represents a profit of 21% (not counting transaction costs).

Next week, I will look at some of the risks associated with calendar spreads. Such as the impact of all things not being equal.

ShareThis

The code for Bombardier January 4.50 calls is BBD AX, where:
BBD represents the option three-character symbol
A represents the expiry month code
X represents the strike price code

Under COSI, this class will be represented BBD 090117C4.50, where:
BBD represents the option root symbol (in the vast majority of cases the options symbols will be the same as the underlying symbol). Up to six characters are available.
090117 represents the expiry date (January 17, 2009 – Saturday following the third Friday, last trading day, of the expiry month)
C represents the option indicator for calls
4.50 represents the strike price

You can see just how explicit the new symbology is.

Again, I want to point out that this is what exchanges will adopt. Your service providers might show a slighlty different representation. So long as you remember the four types of information (option root symbol, expiry date, call/put indicator and strike/decimal), you should be able to recognize your options classes on any end-user application.

ShareThis

ShareThis

In 1938, the Dow Industrials went through a mild correction in September followed by a strong October rally that eventually ended with a November top. Sound familiar? In 2009, the US markets had only the smallest correction in September, followed to this point, by a fairly robust October.

One could argue that the stock market, as a leading economic indicator, is simply predicting a significant upturn in economic activity. Climbing a wall of worry so to speak.

But, observes Lawrence McMillan (www.optionstrategist.com), if “the economic data refuses to improve, the market realizes that it has overshot on the upside and another, slower, bear market unfolds.”

Certainly the sell-off in Goldman Sachs last week, despite a blow out quarter, adds support to that argument. When it comes to earnings, it may no longer enough to knock the ball out of the park. You may need to knock the cover off the ball!

Whether this time is different or history repeats itself, you might consider buying some protection. The cost of insurance has come down as measured by the Montréal Exchange Volatility Index (closed on Friday at 21.98). These are levels not seen since before the crisis began.

The best way to buy insurance is to purchase puts on the iShares S&P TSX 60 Index Fund (TSX: XIU, closed Fridat at $17.20). Look at buying the XIU December 17 puts at 60 cents.

ShareThis

Along with copper’s rally, copper mining companies like Ivanhoe Mines (TSX: IVN, recent price $13.00) have seen share prices soar. Almost like an option contract, Ivanhoe has rallied from a low of $2 to a recent 52-week high of $14. Mainly on an investment agreement with Mongolia for the Oky Tolgoi copper-gold mine. Mining giant Rio Tinto, which holds a 9.9% stake in Ivanhoe, is helping develop the $4 billion project.

But has copper overshot the mark? Some analysts believe it has, as LME copper stocks remain at five-month highs. Continued Chinese buying remains a question mark, and any signal that China’s copper purchase program is being curtailed could send the market into a tailspin – with grievous consequences for momentum-driven stocks like Ivanhoe. Copper prices have stabilized since September and have showed signs of pulling back.

Longer term, Ivanhoe might make a tempting target for Chinese sovereign funds, given the Mongolian property’s proximity to China’s northern border. This begs the question of whether independent Mongolia would ever welcome Chinese ownership of any asset within its borders.

If push came to shove, would China ever risk raising geopolitical tension by attempting to expand its sphere of influence into Mongolia? Certainly the new global power hierarchy is based on a country’s economic prowess, and in the vein, China wields a sizeable stick. A move for an asset like Ivanhoe would assure China access to Mongolia’s vast natural resources, and could have an immediate effect on Ivanhoe’s share price. An impact that could be positive or negative.

Investors who have turned a decent profit holding IVN shares might want to look at hedging their bets. Buying puts is the easiest approach, although the options on IVN are expensive. Currently trading at 55% implied volatility, you could look at buying the December 13 puts at $1.45.

If you believe the cost of insurance is too expensive, you might hedge you bets with a covered call write. In this case, holding your IVN shares and writing the December 14 calls at $1.00.

ShareThis

• remove multiplication of symbols after corporate actions (mergers, takeovers, plans of arrangement);
• cope with the lack of alpha codes to open additional strike prices;
• reduce investors’ confusion;
• simplify the roll-over process of long-term options.

The old symbology has been used for over 25 years and poses several limitations in today’s marketplace. For example, different identifiers in both the options and underlying value is illogicial. The month and call/put codes assume expiration occurs in the following sequential month and assumes a single expiration day.

The new symbology proposes an explicit symbol. This approach will reduce the risk of errors in the front-, middle- and back-office processes. It will also provide exchanges with a greater flexibility in product development.

The Montréal Exchange will represent its options quotes using four fields:

Class symbol (up to 6 characters):
The underlying root symbol will be the option symbol.

Expiration date:
New format used YYMMDD
For index options (2 characters): expiring Friday (3rd Friday of the expiry month).
For currency options (2 characters): expiring Friday (3rd Friday of the expiry month).
For ETF and equity options (2 characters): expiring Saturday (Saturday following the 3rd Friday of the expiry month – last trading day).

Call or put indicator (1 character):
C for calls and P for puts.

Strike price (total of 8 characters available - 5 for dollars and 3 decimals):
In dollars and decimals.

The new symbology proposes a standard model that all exchanges will adopt. However, because of field constraints, the display on some systems (vendors and brokers) could be slightly different. You must contact your broker to discuss how the firm will be displaying options in account statements and end-user applications.

Right now, the Montréal Exchange disseminates its options quotes under both symbologies. Our systems are ready and brokers are testing their applications.

Our team will elaborate several communication strategies, including posts in the blog, to keep you up to date with this milestone initiative.

Meanwhile, I encourage you to contact your service providers to get the specifics on how options will be display on their applications following the implementation of the new symbology.

ShareThis

But what about times when you are not certain about direction? When you would normally sit on the sidelines waiting for the market to make a new high, or better yet, go through a mild correction in order to create a buying opportunity. In many ways, probably what you are thinking right now!

Rather than sitting on the sidelines you might consider the long straddle. A long straddle is the simultaneous purchase of both a call and a put with the same strike price. For example, with XYZ at $50, you could buy a six-month XYZ 50 call (trading at $5 per share) and a six-month XYZ 50 put (trading at $4 per share) for a net debit of $9 per share.

Having purchased both a call and a put, you are no longer concerned about direction. The call makes money if the stock rises, the put profits if the stock declines. The challenge is that XYZ moves more than $9 per share, to overcome the cost of the two options.

What the straddle is really doing is framing a trading range for the underlying stock. In the case of XYZ, the six-month implied trading range is $41 to the downside and $59 to the upside. The implied trading range is defined in the options world as implied volatility.

The problem with implied volatility is that it is a percentage number, which doesn’t tell investors much. The implied trading range tells us what trading range the options market believes is reasonable for the underlying stock. As such, a straddle is really a volatility trade.

Of course you can either buy or sell a straddle. Although at this stage of the market, I think buying straddles makes more sense. First of all, you are unlikely to lose the entire cost of the straddle. With the XYZ example, the stock would have to close at exactly $50 per share on expiration day, which is not a likely scenario.

Secondly, when traders are anticipating a correction after a serious market rally – sound familiar – volatility contracts and straddles become an interesting alternative strategy. The problem with trying to pick a top when you believe the market is acting irrationally is the market can often act irrational for longer than you can afford to bet against it. The straddle, especially if the price is reasonable, can provide a short term strategy that benefits if other traders come to the same conclusion as you, but also, if market participants continue to act irrationally.

ShareThis

http://www.optionsource.net/mediaplayercanadian.php

For more information on the XIU options, click on the link below:

http://www.m-x.ca/nego_cotes_en.php?symbol=XIU*&image.x=12&image.y=9

Regards,

Patrick Ceresna

ShareThis

Longer term, however, one could argue that certain sectors will continue to grow, benefiting from a rebound in the global economy.

For the TSX, the sectors most likely to experience robust growth going into 2010 are energy and materials. Longer-term demand for these resources is unlikely to wane. Suggesting that prices are likely to improve as existing inventories are depleted and new production lags.

So despite the view that a pullback is likely, a bullish case can be made for long-term bullish positions in select liquid, optionable energy and mining issues, as well as in optionable exchanged-traded funds such as the iShares CDN Energy Sector Index Fund (TSX: XEG, $17.81). Specifically, you could look at buying the XEG March 18 calls at $1.30.

In the materials sector, you could look at Agrium (symbol AGU, recent price $52.57) January 54 calls at $3.50. More conservative investors might consider covered calls or cash secured puts on AGU. That is buying the shares at $52.57 and writing the January 56 calls at $2.70. If you prefer cash secured puts, look at writing the AGU January 48 puts at $2.20 per share.

When writing puts, remember that you are assuming an obligation to buy the underlying shares at the strike price of the put. In this case, $48 per share. As such, when we say “cash secured” puts, it means that you have sufficient cash in your account to buy the stock should the put be assigned. If you are writing say five puts you have an obligation to buy 500 shares of AGU at $48 per share, which means you should have set aside $24,000 ($48 x 500 shares = $24,000) in case to meet your obligation.

ShareThis