First Solar Inc. ( FSLR ) has been quite popular among bearish options traders recently, with the stock making notable appearances in International Securities Exchange (ISE) options data twice in the past week - once on Tuesday, Dec. 7, and again on Thursday, Dec. 9. FSLR has once again attracted heavy put volume today, with more than 13,000 contracts changing hands so far. However, there was at least one trader with neither bullish nor bearish designs, offering up an example of an expiration-week 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 75 December 140 puts traded at about 11:47 a.m. Eastern time on the International Securities Exchange (ISE) for the bid price of $4.86. At the same time and on the same exchange, 75 January 2011 140 puts changed hands for the ask price of $8.61. Given this data, it would appear that we are looking at a potential calendar spread on First Solar. This strategy is also known as a time spread, or a horizontal spread.
The Anatomy of a First Solar 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 FSLR calendar spread, the trader sold 75 December 140 puts for $36,450 -- ($4.86 * 100) * 75 = $36,450. At the same time, the trader purchased 75 January 2011 140 puts for $64,575 -- ($8.61 * 100) * 75 = $64,575. The total outlay for this position would be $28,125 -- $64,575 - $36,450 = $28,125.
The maximum loss on this trade is limited to the initial net debit of $3.75, or $375 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 put, minus the net debit paid to establish the position. The maximum profit is achieved if FSLR closes at $140 per share on December expiration.
Since there are two expiration dates for this trade, and we cannot know for certain what the exact value of the January 2011 140 put will be when the December 140 put expires, we can only estimate the approximate return on the FSLR calendar spread. In the best-case scenario, FSLR would close at the 140 strike when December options expire, allowing the December 140 put to expire worthless. At that point, the January 2011 140 put would be worth only its time value and implied volatility -- no intrinsic value.
In this example, the January 2011 140 put will be worth an estimated $7.41 at December expiration, according to IVolatility.com's pricing calculator, allowing the trader to sell to close the position for $7.41 per contract. After subtracting out the cost of the position ($3.75), the trader would snag a profit of $3.66, or $366 per contract. Below is a chart for a rough visual representation:
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 FSLR December 140 put arrived at 49.67%, while the implied volatility for the January 2011 140 put rested at 41.39%. For comparison, as of the close of trading on Thursday, FSLR's one-month historical volatility rested at 43.13%, while the stock's two-month historical volatility was 41.93%.
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