30 lines
2.0 KiB
Plaintext
30 lines
2.0 KiB
Plaintext
Rolling and Earning a “Free” Call
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Many traders who trade income-generating strategies are conservative.
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They are happy to sell low IV for the benefits afforded by low realized
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volatility. This is the problem-avoidance philosophy of trading. Due to risk
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aversion, it’s common to trade calendar spreads by buying the two-month
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option and selling the one-month option. This can allow traders to avoid
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buying the calendar in earnings months, and it also means a shorter time
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horizon, signifying less time for something unwanted to happen.
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But there’s another school of thought among time-spread traders. There
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are some traders who prefer to buy a longer-term option—six months to a
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year—while selling a one-month option. Why? Because month after month,
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the trader can roll the short option to the next month. This is a simple tactic
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that is used by market makers and other professional traders as well as
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savvy retail traders. Here’s how it works.
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XYZ stock is trading at $60 per share. A trader has a neutral outlook over
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the next six months and decides to buy a calendar. Assuming that July has
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29 days until expiration and December has 180, the trader will take the
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following position:
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The initial debit here is 2.55. The goal is basically the same as for any
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time spread: collect theta without negative gamma spoiling the party. There
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is another goal in these trades as well: to roll the spread.
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At the end of month one, if the best-case scenario occurs and XYZ is
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sitting at $60 at July expiration, the July 60 call expires. The December 60
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call will then be worth 3.60, assuming all else is held constant. The positive
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theta of the short July call gives full benefits as the option goes from 1.45 to
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zero. The lower negative theta of the December call doesn’t bite into profits
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quite as much as the theta of a short-term call would.
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The profit after month one is 1.05. Profit is derived from the December
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call, worth 3.60 at July expiry, minus the 2.55 initial spread debit. This
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works out to about a 41 percent return. The profit is hardly as good as it |