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Generate Income Trading Options
As we all know, the passage of time affects the premium of options, particularly the OTM options, the less an option is ITM the more the factor of time decay matters (The Theta metric) we know that this time decay accelerates as soon as the option enters the final 30 days of its term, and at expiration date the time element will have completely diminished to zero! The fact that this time element in the options premium extrinsic value, declines exponentially and not linearly, offers the opportunity to profit from a trend-less security over a course of 15-30 days.
Notice how time decay occurs:
The first thing we have to do to implement this strategy, is to find stocks that will actually remain trend-less during these 15-30 days. In order to do that we have to know the status of the whole market, as well as the individual stock or stocks we want to use.
One simple method is based on the following, you can implement this strategy during periods where the option volatility index (VIX) is relatively low, and this can indeed stay low for months, so it’s not a problem, then look for stocks where the ADX indicator is below 20 (That is the Average Directional Index, and measures how strong a stock’s trend is).
As you can see on the above chart, the stock in question had an ADX below 20, and even though it fluctuated slightly, it finished the month at exactly where it started.You can also check the ADX readings of the major indices to figure out if a strong trend is in place or if we are about to enter a flat market period.
As long as the above criteria are met, we are safe to pick even high Beta stocks, just as long as they are in trend-less mode too, the higher Beta means higher volatility and higher extrinsic value, which means more margin for profit in your calendar spreads strategy.
Implementing the idea as follows:
Once you have found the stock, you have to find two identical options on it, that only differ in expiry terms, for example they are both Call options, they have same strike price, but one expires in 30 days and the other expires in 60 days. Ideally you want OTM options, but not too far from the money!
By buying the one that’s further away from expiration and writing the one that has 30 days left, you pay the premium on the one you buy, and get paid on the one you write, but due to the inequality in time decay, the 30 day written Call, which is your liability, will decline much faster than the 60 day long Call, that is it will decline in terms of time element value, that’s why we prefer to deal with ATM options, as they have the highest, safest premiums.
Example:
Consider a stock trading today at $50, we expect this stock to remain flat for at least 30 days based on the criteria mentioned earlier. We create the spread based on two identical Call options that only differ in expiry dates, volatility is slightly different but we don’t expect any dramatic influence from that for the 30 days we are interested in.
You write (sell) the soon expiring June 50 Call, this credits your account with 1.96 ($196), and you buy the longer term July 50 Call for 2.53 ( you pay $253), your total cost is $57 plus commissions.
If it all goes well, then 30 days later you have:
Your written Call liability has declined to zero, but your long Call is still worth $172, so if you sell it now, you have realized a total profit of $115 less commission costs.
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