A how to.
music selection: “Flowers” — Talking Heads
A great way to use options is with net debit spreads. These combine the leverage of long contracts with the income of short contracts. They play both ends against the middle to create a hybrid instrument with defined risk, lowered cost of entry into a trade, and great profit potential. I am going to demonstrate a calendar spread with PepsiCo (PEP).
A calendar spread makes m0ney from the decay of time value, similar to a covered call. It has a lower capital requirement and greater leverage. They are ideal for large slow moving mature companies. PEP is ideal as a mega cap with a 0.50 Beta. You want to pick a strike that is at the money (your maximum profit comes if you close the spread with the underlying exactly at the strike.) Time decay is a little funny because it is not linear over the lifetime of a contract. The fast time decay occurs between with 2 to 8 weeks left till expiry. This is what we want to exploit by selecting for our short leg an expiry right around 8 weeks out. In this case I’m going with PEP191018P00140000 for the short leg. I am using the puts but you can also build this spread with the at the money calls. The most recent pricing was 4.75 a share.
Likewise, you would buy a long put at the same 140 strike but with a longer dated expiry. In this case, the next expiry currently available is in January – PEP200117P00140000. The most recent pricing is 7.20 a share. This would make your net debit on the spread 7.20 – 4.75 = 2.45. You will put at risk only 245 dollars per spread, whereas a covered call would have required 14,000 in cash or margin.
Let’s look at the profit potential. The trade will be in force for a maximum of 44 days, the duration of the short contract. At that time, there would be 91 days left till expiry on the long contract. We can estimate the time value using the online calculator at https://www.cboe.com I get 5.96 using the calculator and assuming the price of the underlying is unchanged. That is 143% over 44 days. The annualized return would be 1,188%. It is important to remember there is a chance to lose money on this trade if the price of the underlying moves far from the selected strike. Monitor your position and exit early if things are going against you to recover as much remaining time value as possible.
I’ll also note that time value decay really slows down when there is only 5-7 days remaining on the contract. You are playing a game where you want the short expiry to decay faster than the long dated expiry. Thus, it makes a lot of sense to close the spread a week or so early for maximum profit. Always use combo orders to enter and exit spreads. The prices can move quickly and you can get bad fills if you try to “leg in” to a spread.
In conclusion, in my modeling and trading the calendar spread is the most profitable spread that has limited risk. Your risk is limited to the net debit you take when opening the spread. I’ll be back next Wednesday to discuss what to do on the bear put spread, bull call spread, and/or calendar spread if your short contract gets assigned early.
Devour your prey raptors!