Since volatility tends to decline in the wake of a company's
quarterly earnings report, advanced traders often seek out ways to
take advantage of the corresponding drop-off in option implieds.
While digging through today's activity on CF Industries Holdings
Inc. (
CF
), I found a solid example of a post-earnings options strategy
specifically designed to take advantage of declining volatility: a
calendar spread.
For the uninitiated, calendar spreads are generally neutral in
terms of movement in the underlying stock - though you can skew the
spread bullishly or bearishly by altering the strike prices.
Ultimately, this strategy is designed to take advantage of
declining implied volatility, with the trader typically betting on
little-to-no movement from the underlying stock. As such, traders
employing this options strategy tend to avoid entering calendar
spreads ahead of events such as earnings reports.
Getting down to the trade itself, a block of 1,000 August 85
calls traded at about 10:23 a.m. Eastern time on the New York Stock
Exchange (NYSE) for the bid price of $0.94. At the same time and on
the same exchange, 1,000 September 85 calls changed hands for the
ask price of $2.85. Given this data, it would appear that we are
looking at a potential
calendar spread
on CF Industries Holdings. This strategy is also known as a time
spread, or a horizontal spread.
The Anatomy of a CF Industries Holdings Calendar
Spread
Now, this setup may not make a lot of sense to beginning options
traders, but the investor above is looking for accelerated erosion
in the implied volatility of the front-month option, which he hopes
to buy back at expiration for practically nothing, while collecting
a larger premium by selling to close the back-month option.
Drilling down on today's CF calendar spread, the trader sold
1,000 August 85 calls for $94,000 -- ($0.94 * 100) * 1,000 =
$94,000. At the same time, the trader purchased 1,000 September 85
calls for $285,000 -- ($2.85 * 100) * 1,000 = $285,000. The total
outlay for this position would be $191,000 -- $285,000 - $94,000 =
$191,000.
The maximum loss on this trade is limited to the initial net
debit of $1.91, or $191 per contract. Meanwhile, the maximum profit
is limited to the premium received for the back-month option when
it is sold to close out the position, minus the cost to buy back
the front-month call, minus the net debit paid to establish the
position. The maximum profit is achieved if CF closes at $85 per
share on August expiration.
Since there are two expiration dates for this trade, and we
cannot know for certain what the exact value of the September 85
call will be when the August 85 call expires, we can only estimate
the approximate return on the CF calendar spread. In the best-case
scenario, CF would close at the 85 strike when August options
expire, allowing the August 85 call to expire worthless. At that
point, the September 85 call would be worth only its time value and
implied volatility -- no intrinsic value.
In this example, the September 85 call will be worth an
estimated $3.22 at August expiration, according to
IVolatility.com's
pricing calculator, allowing the trader to sell to close the
position for $3.22 per contract. After subtracting out the cost of
the position ($1.91), the trader would snag a profit of $1.31, or
$131 per contract. Below is a chart for a rough visual
representation:
Implied Volatility
The most ideal calendar spread trade occurs when near-month
implied volatilities are high relative to options with a longer
life. Optimally, the spread trader needs implied volatility to
remain steady on the shorter-term sold option (or to increase on
the purchased option). The best-case scenario for a calendar spread
is that the sold option expires out of the money, while the
purchased option retains time premium. At the time of the trade,
implieds for the CF August 85 call arrived at 41.28%, while the
implied volatility for the September 85 call rested at 41.69%. For
comparison, as of the close of trading on Monday, CF's one-month
historical volatility rested at 24.91%, while the stock's two-month
historical volatility was 25.67%.
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