Options Trade of the Day: A Wynn Resorts Ltd. Calendar Spread

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Wynn Resorts Ltd. (WYNN) has garnered quite a bit of attention from put traders today, despite the fact that the shares have soared to a fresh multi-year high. WYNN may be riding the coattails of fellow gaming concerns MGM Resorts (MGM) and Boyd Gaming ( BYD ), which drew bullish research notes from Bank of America/Merrill Lynch earlier today. That said, put volume has nearly tripled WYNN's daily average, with more than 5,100 contracts changing hands so far. However, there was at least one trader with neither bullish nor bearish designs, offering up an example of a strategy 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 168 February 120 puts traded at about 10:17 a.m. Eastern time on the International Securities Exchange (ISE) for the bid price of $3.29. At the same time and on the same exchange, 168 March 120 puts changed hands for the ask price of $5.64. Given this data, it would appear that we are looking at a potential calendar spread on Wynn Resorts. This strategy is also known as a time spread, or a horizontal spread.

WYNN February 120 and March 120 put volume

The Anatomy of a Wynn Resorts 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 WYNN calendar spread, the trader sold 168 February 120 puts for $55,272 -- ($3.29 * 100) * 168 = $55,272. At the same time, the trader purchased 168 March 120 puts for $94,752 -- ($5.64 * 100) * 168 = $94,752. The total outlay for this position would be $39,480 -- $94,752 - $55,272 = $39,480.

WYNN calendar spread breakdown

The maximum loss on this trade is limited to the initial net debit of $2.35, or $235 per pair of contracts. 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 put, minus the net debit paid to establish the position. The maximum profit is achieved if WYNN closes at $120 per share on February expiration.

Since there are two expiration dates for this trade, and we cannot know for certain what the exact value of the March 120 put will be when the February 120 put expires, we can only estimate the approximate return on the WYNN calendar spread. In the best-case scenario, WYNN would close at the 120 strike when February options expire, allowing the February 120 put to expire worthless. At that point, the March 120 put would be worth only its time value and implied volatility -- no intrinsic value.

In this example, the March 120 put will be worth an estimated $4.97 at February expiration, according to IVolatility.com's pricing calculator, allowing the trader to sell to close the position for $497 per contract. After subtracting out the cost of the position ($2.35), the trader would snag a profit of $2.62, or $262 per contract. Below is a chart for a rough visual representation:

WYNN calendar spread profit/loss chart

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 WYNN February 120 put arrived at 40.23%, while the implied volatility for the March 120 put rested at 47.21%. For comparison, as of the close of trading on Monday, WYNN's one-month historical volatility rested at 26.36%, while the stock's two-month historical volatility was 27.35%.

The winter 2011 issue of SENTIMENT magazine is now available here.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

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This article appears in: Investing , Options

Referenced Stocks: BYD

Schaeffer's Investment Research

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