Wisdom on Spreads of All Kinds
Editor's Note: In the column below, originally published Feb. 26, we gave a bum steer on the explanation of exactly what makes a spread a calendar spread.
In responding to reader Bill Tucker's question, we mistakenly said: Essentially, a calendar spread is an options strategy for when you feel bullish or bearish about an underlying stock, but lack confidence as to the timing of your hunch.
To play on the time element of options, you can buy or sell options with a few months, or even years, in between expiration dates. (Usually with a calendar spread, the options expiration date is different, but the strike price is the same.)
In fact, a calendar spread is the simultaneous sale of a short-dated option and the purchase of a longer-term option with the same strike price. You don't buy both, as we suggested; you sell one and buy another. In addition, it's best used as a strategy when you're feeling neutral and have no real belief that the stock will move far in either direction.According to Larry McMillan's Options as a Strategic Investment, the idea is that "time will erode the value of the near-term option at a faster rate than it will the far-term option." Here's an example from the same chapter in McMillan: A stock is at 50 -- you sell the April 50 call for 5 and buy the July 50 call for 8. The cost of that investment is the 3-point difference between what you take in for the April call and what you spend on the July call. The difference comes from the increased time value portion of the option's premium. Because that time value erodes as the options get closer to expiration, if the stock is still sitting at 50 by the April expiration, the call you sold expires worthless and the July call is now 5. That means the profit from the trade is 2 (5 minus 3). Again, this works well when you're not expecting the stock to move. Selling options, especially near-term ones, can be a costly exercise if the stock moves beyond the strike price. In the case of calls, you'll have to go out and buy the stock and then sell it at a lower price (the strike price) to fulfill your end of the contract; if it's a put, you may end up paying 50 for a stock that's worth 55 and be forced to hold onto it for another two months, when the put you bought expires.
Back Spread AddendumOK, we finally got the answer to reader Ed Peterson's question from last week's Options Forum. What's a back spread? Larry McMillan's terrific book Options As a Strategic Investment lists a back spread as "the reverse of any known strategy." In other words, it's the reverse of the option strategy you already have on, Ed. Sounds like more commissions -- expensive and complicated. Stay away.
Chicago: City of Broad Shoulders and Cheap QuotesIf you're an active investor and 20 minutes seems like an eternity to wait for a quote, then the agony is over. Leveling the playing field for individual investors, the Chicago Board Options Exchange this week offered real-time quotes in conjunction with Reuters. And you can pay, over the Internet, with your credit card. Yowza! You can visit the CBOE's Web site (there's a big announcement on the home page) for information on getting unlimited quotes on stocks, options, mutual funds and indices for a low flat monthly fee. The subscription fees for Real-Time Quotes are $7 a month, plus exchange fees that are $1 for options and all but Nasdaq-traded equities, which will cost you two bucks. We don't know about you, but this is the coolest thing to hit the industry since multiple listing of options. (As always, TheStreet.com doesn't endorse any other Web sites.)
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