Use Options to 'Time' Housing's Top

Before explaining how to profit from this calendar spread, let's look briefly at another scenario in which lower prices could actually result in a loss. Let's say that the stock has fallen below $45 a share prior to the September expiration. Assuming you did nothing prior to the expiration date, you would most likely get assigned on your short put options, meaning that the buyers have exercised their option, requiring you, the put seller, to buy shares of Toll Brothers.

At this point you might choose to simply close the position by selling out assigned stock, and sell your long puts. Because the January 2007 puts, with more than 15 months remaining until expiration, would still be awarded significant time premium, the loss would likely be much less than the stated $5.25 risk. But you should be aware that there is a scenario in which you can be right in judging the stock's next move but still lose money.

Now, here are a couple of scenarios for making the calendar spread profitable, beginning with certain assumptions.

First, if the September $45 put expires worthless, meaning you are now outright long the January 2007 LEAP, one might the look to sell short the next front-month option. Another possibility is that on Sept. 19, the Monday after expiration, if Toll is still trading around $49, you could sell the October 2005 $45 put for around $1.25 per contract. (I used a basic option calculator to arrive at this price.) This will further reduce the cost and risk to $4 per spread.

Theoretically, assuming Toll shares and other variables remain constant, it would take about five option cycles, or expiration months, to pay for the January 2007 puts. Of course, it is likely the stock will change price, and this could either accelerate or lengthen the time period it takes to pay off the initial cost. So depending on how the stock trades, a myriad choices and possible adjustments are possible -- and too numerous to list.

But the concept of continually rolling forward and selling the near-term contract is a way to take advantage of the fact that the rate of time-premium decay accelerates as the option approaches expiration. This will continually raise the break-even point and, as mentioned above, can ultimately create a position that has no cost or risk but an unlimited profit potential with plenty of time on its side.