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An Interesting Calendar Spread Trade Idea

Today I would like to share with you an investment I made in my personal account just today.  It involves buying three calendar spreads and waiting about a month to see if you hit the jackpot.  See if you agree with me that it is a potentially great trade.Terry

An Interesting Calendar Spread Trade Idea 

The underlying company is Keurig Green Mountain Coffee (GMCR).  I have traded options on this company almost every week for the last few years.  I like it because the options carry an exceptionally high implied volatility (IV) because the stock has been so volatile.

A few months ago, when Coke signed an exclusive license with them and agreed to buy 10% of the company, the stock shot up by about 50%.  It has since retreated from those lofty levels, recently pushed lower because several competitors have brought a suit against them because their new Keurig machine won’t accept other companies’ single cup offerings.  That sounds like a good business idea to me, not something that they could be sued over.  But our legal system never ceases to surprise me.

In any event, the stock has settled down a bit, and since the lawsuits won’t get anywhere for several months, I only care what happens in the next month.  The stock closed at $98 Friday.  I think it won’t go much lower than that, and maybe will edge higher over the next month.

I am buying June options and selling May options as a calendar spread.  I bought June 105 calls and sold May 105 calls, June 100 calls and sold May 100 calls, June 95 puts and sold May 95 puts, all as calendar spreads.  The natural price for the call spreads was $2.00 and for the puts, $1.70 (you should be able to pay a little less than the natural prices).

In one month, when the May options expire (on the 16th), if any of those three strike prices are at the money (i.e., the stock price is very near one of the strike prices), the May option will expire nearly worthless and the June option should be worth $6.35 (based on the current value of an at-the-money option with four weeks of remaining life).  That means if I could get back more than I paid for all three spreads today by selling a single spread a month from now.  Whatever I got from selling the other two spreads would be pure profit.

If the stock ends up on May 16th being $5 away from one of my 3 strike prices, based on today’s values, the spread could be sold for $4.45, or more than double what I paid for any of the spreads I bought.  If the stock is $10 away from a strike price, it could be sold for $3.05 based on today’s prices.  That is 50% more than I paid for any of the spreads.

However, the company announces earnings on May 7th.  Because of the uncertainty surrounding that event, option prices are much higher now than they will be after the announcement.  IV for the June options is 55 right now, and it is only 44 for weekly options that expire before the announcement.  If we assume that IV for the June options will fall by 11 after the announcement, this is what the risk profile graph looks like:

GMCR Risk Profile Graph April 2014

GMCR Risk Profile Graph April 2014

This graph has numbers for 5 calendar spreads at each of the 3 strikes, with a total investment of about $4800.  If the stock ends up flat or up to $7 higher than it is right now, there would be about a 60% gain from the spreads.  If it falls by $10 (an unlikely event, in my opinion), a loss of about $400 would result.  Although the graph does not show it, the upside break-even is $15 higher than the current price.  It shows that above $113, losses would result.

Many stocks move higher in the few days before an announcement in anticipation of good results, a good reason I like to have a little more coverage on the upside (if you are more bullish, you would buy more spreads at higher strike prices, and if your were bearish on the company or the market, you would buy more spreads at lower strike prices).

One nice thing about calendar spreads is that the options you buy have a longer life span than those you are selling, so their value will always be higher, no matter how far from the stock price they might be.  You can never lose all of your money with a calendar spread, unlike who might happen in a vertical spread or short iron condor, two popular option spreads.

If the stock moves dramatically either way between now and announcement day, I would add another calendar in the direction the stock has moved (at the 115 strike if it moves higher, or the 90 strike if it moves lower).  That move would give me a wider break-even range than presently exists.

I will report back to you on how these spreads turn out in four weeks.

 

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