Tuesday, July 26, 2011

Option 101 - Modeling Calendar Spreads part II

As traders, it is prudent to model potential positions as part of ones due diligence prior to entering a particular trade.

With the aid of option simulation software, modeling can allow one to analyze all the relevant risks (delta, gamma, theta, vega) and understand the maximum loss and gain for any position over time.

The example used for this post is slightly different than the previous post. It is the 11-strike out-of-the-money August/September calendar spread for BAC. Notice the differences in the risk profiles between the two as this example, which is considered out-of-the-money, carries more profit potential. This is because out-of-the-money options carry more risk due to the larger price swing needed to be in-the-money. As a result, they are priced at a discount to compensate for the additional risk.

Courtesy of Option Oracle, above is the theoretical pay off diagram for the position based on the price of BAC on August 20, the expiration day for front month of the spread. Furthermore, shown below, is the theoretical payoff diagram for the position based on varying volatility levels.

In this calendar spread example, the maximum risk, $12 per spread position, is calculated as the net premium outlay for the position.

The maximum profit potential by August 20 is $30.27 per spread position (252.24%). It is calculated based on ideal assumptions for the underlying and various Greeks. Specifically, it assumes volatility levels for each contract will remain constant and that the position will remain slightly delta positive per spread. Hence, it assumes there will be little price fluctuation. Consequently, because reality generally deviates from theory, it is highly recommended that sensitivity analysis be performed on all assumptions in any model.

Fortunately, option modeling programs like Option Oracle, allow one to do just that. As a cautionary concluding note, remember markets are dynamic and as a result, assumptions and decisions based on them must be constantly updated to maintain one's edge.

http://seaofopportunity.blogspot.com/*Special thanks to Option Radar, BMO Capital, MEB Options, Bloomberg, Reuters, Optionistics, LiveVolPro, CBOE, AMEX, Option Monster, T.O.P. group, and all of the options desks and traders we work with to provide the option flow!No position at this time. Position declarations are believed to be accurate at time of writing but may change at any time and without notice.

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