OTM LEAP call calendar spreads - Comments/thoughts?

[MDCigan]

This is a trade idea I have been playing around with. The idea is to try and structure a trade that has a very high upside potential with minimal risk for long-term structural/secular trends.

Necessary trade conditions to use this:

1. Fundamental - You believe the market/underlying is fundamentally undervalued from a long-term perspective (1-2 year outlook) and have solid fundamental reasons for significantly higher prices.

2. Technical - The market/underlying appears to be in a solid long-term uptrend. It is trading above 200 day MA, likely trading above 50 day MA and either MA has held as support on multiple tests.

3. Volatility - Implied volatility on the options, specifically the LEAPS is relatively low.

As an example, I believe that XAU and NEM currently meet these criteria. I think it's quite obvious that the technical uptrends for XAU and NEM are very strong. I won't get into all the nitty gritty of the fundamental reasons for much higher gold prices unless somebody is interested but I think the U.S. trade deficit, U.S. budget deficit, weakening dollar all point to much higher gold prices.

Here is the general idea. The idea is on pullbacks to support and/or on oversold (however you define oversold, I use stochastics) conditions, you initiate a SMALL position in the longest dated OTM LEAP call (would currently be 2006). What the optimal amount OTM is I am still playing around with. Then on the next short-term rally to overbought condition you sell short the 2005 LEAP call at the same strike price for hopefully the same amount you paid for the 2006 LEAP call thus creating a "free" trade that has significant upside potential if the market keeps trending up. As opposed to just buying OTM calls you have theta working for you instead of against you.

Next pullback. Buy more 2006 LEAP calls. Next rally. Sell more 2005 LEAP calls. Rinse and repeat. This would theoretically allow one to build a very large position in long-term calls with hopefully minimal risk. The key would be to never purchase too many long calls to start in case the trend breaks down and/or long-term fundamental reasons evaporate.

The devil is in some of the details. I'm finding playing around with the numbers that a greater then expected price difference in the underlying is needed to make the 2006 and 2005 LEAP call prices equal (to create the "free" trade). I'm wondering if that is possibly because I am looking to far OTM. I'm wondering if there is some optimal strike in terms of OTM from current price where maybe only a 10-15% price rise in the underlying would make selling a 2005 LEAP equal to the 2006 LEAP purchased 15% lower.

Any comments/thoughts would be appreciated.

 

[TempusFugit]

Quote from MDCigan:

This is a trade idea I have been playing around with. The idea is to try and structure a trade that has a very high upside potential with minimal risk for long-term structural/secular trends.

Necessary trade conditions to use this:

1. Fundamental - You believe the market/underlying is fundamentally undervalued from a long-term perspective (1-2 year outlook) and have solid fundamental reasons for significantly higher prices.

2. Technical - The market/underlying appears to be in a solid long-term uptrend. It is trading above 200 day MA, likely trading above 50 day MA and either MA has held as support on multiple tests.

3. Volatility - Implied volatility on the options, specifically the LEAPS is relatively low.

As an example, I believe that XAU and NEM currently meet these criteria. I think it's quite obvious that the technical uptrends for XAU and NEM are very strong. I won't get into all the nitty gritty of the fundamental reasons for much higher gold prices unless somebody is interested but I think the U.S. trade deficit, U.S. budget deficit, weakening dollar all point to much higher gold prices.

Here is the general idea. The idea is on pullbacks to support and/or on oversold (however you define oversold, I use stochastics) conditions, you initiate a SMALL position in the longest dated OTM LEAP call (would currently be 2006). What the optimal amount OTM is I am still playing around with. Then on the next short-term rally to overbought condition you sell short the 2005 LEAP call at the same strike price for hopefully the same amount you paid for the 2006 LEAP call thus creating a "free" trade that has significant upside potential if the market keeps trending up. As opposed to just buying OTM calls you have theta working for you instead of against you.

Next pullback. Buy more 2006 LEAP calls. Next rally. Sell more 2005 LEAP calls. Rinse and repeat. This would theoretically allow one to build a very large position in long-term calls with hopefully minimal risk. The key would be to never purchase too many long calls to start in case the trend breaks down and/or long-term fundamental reasons evaporate.

The devil is in some of the details. I'm finding playing around with the numbers that a greater then expected price difference in the underlying is needed to make the 2006 and 2005 LEAP call prices equal (to create the "free" trade). I'm wondering if that is possibly because I am looking to far OTM. I'm wondering if there is some optimal strike in terms of OTM from current price where maybe only a 10-15% price rise in the underlying would make selling a 2005 LEAP equal to the 2006 LEAP purchased 15% lower.

Any comments/thoughts would be appreciated.

Hello MD, a few top-of-mind comments

Interesting strategy and it strikes me that most of the major indices arguably meet your criteria.

I checked XAU and NEM on optionsXpress. XAU does not appear to have LEAPS listed. NEM does but they are VERY thinly traded. There are less than 5000 contracts OI total on each of the Jan 05 and Jan 06 calls for all OTM strikes. I suspect you would be mainly trading vs. the market makers which would make me very nervous.

So, I thought, why not try it with an index, especialy given the recent pullback. E.g., RSI on QQQs signalling buy this morning.

Some numbers:

buy Jan 06 45s for $2.15 (with QQQ at 34.21)
Jan 05 45s currently at .90 with delta of roughly .20

This means that for the Jan 05 45s to move 2.15-.90=1.25 we would need a move of 1.25/.20=6.25 in the underlying or QQQ=40.46, an 18% move.

Try the 40s: Jan 06 40 is 3.60; Jan 05 40 is 1.95 with delta of roughly .35.

This means that for the Jan 05 40s to move 3.60-1.95=1.65 we would need a move of 1.65/.35=4.71 or QQQ=38.92, a 14% move

Try NEM: Jan 06 55s at 6.90 (with NEM at 45.20); Jan 05 55s at 4.10 with delta of roughly .40.

This means that for the Jan 05 55s to move 6.90-4.10=2.80 we would need a move of 7.00 or NEM at 52.20, a 15% move.

So...these seem to fit your general conditions...hope it helps.

But, why do these OTM? The closer to ATM (or ITM) you get, the larger the delta and hence the smaller the required swing.

And, really this is just legging into a calendar spread, right? If you catch the first leg at the wrong time (stochs mis-lead 20% of the time?) you might not get the chance for the second leg for a long time. And as Lord Keynes said, in the long run, we're all dead.

Also, please check my math as it is late and I've done done the calculations on my old HP12c calculator. And of course, the deltas are rough and will change as the underlying moves, so these figures are very approximate.

Good luck,

TF

 

[Maverick74]

Quote from MDCigan:

This is a trade idea I have been playing around with. The idea is to try and structure a trade that has a very high upside potential with minimal risk for long-term structural/secular trends.

Necessary trade conditions to use this:

1. Fundamental - You believe the market/underlying is fundamentally undervalued from a long-term perspective (1-2 year outlook) and have solid fundamental reasons for significantly higher prices.

2. Technical - The market/underlying appears to be in a solid long-term uptrend. It is trading above 200 day MA, likely trading above 50 day MA and either MA has held as support on multiple tests.

3. Volatility - Implied volatility on the options, specifically the LEAPS is relatively low.

As an example, I believe that XAU and NEM currently meet these criteria. I think it's quite obvious that the technical uptrends for XAU and NEM are very strong. I won't get into all the nitty gritty of the fundamental reasons for much higher gold prices unless somebody is interested but I think the U.S. trade deficit, U.S. budget deficit, weakening dollar all point to much higher gold prices.

Here is the general idea. The idea is on pullbacks to support and/or on oversold (however you define oversold, I use stochastics) conditions, you initiate a SMALL position in the longest dated OTM LEAP call (would currently be 2006). What the optimal amount OTM is I am still playing around with. Then on the next short-term rally to overbought condition you sell short the 2005 LEAP call at the same strike price for hopefully the same amount you paid for the 2006 LEAP call thus creating a "free" trade that has significant upside potential if the market keeps trending up. As opposed to just buying OTM calls you have theta working for you instead of against you.

Next pullback. Buy more 2006 LEAP calls. Next rally. Sell more 2005 LEAP calls. Rinse and repeat. This would theoretically allow one to build a very large position in long-term calls with hopefully minimal risk. The key would be to never purchase too many long calls to start in case the trend breaks down and/or long-term fundamental reasons evaporate.

The devil is in some of the details. I'm finding playing around with the numbers that a greater then expected price difference in the underlying is needed to make the 2006 and 2005 LEAP call prices equal (to create the "free" trade). I'm wondering if that is possibly because I am looking to far OTM. I'm wondering if there is some optimal strike in terms of OTM from current price where maybe only a 10-15% price rise in the underlying would make selling a 2005 LEAP equal to the 2006 LEAP purchased 15% lower.

Any comments/thoughts would be appreciated.

OK, I have to ask this. what exactly are you trying to do? This trade does not have that much upside and the purpose of calendars is to capture time decay on the front month position. By selling an 05 leap and buying an 06 there is no time decay and almost no difference between the two legs. There really is no edge in doing this trade. Long calendars are worthless if you are not earning any time premium on them. And I really am not sure your idea of legging into them is very good. If you want to do a leap trade. Buy the jan 06 and sell front month every month for the next 24 months and earn the premium. And since you are long vega on the back month you have unlimited upside on the vol. This would make you 100 times as much money as the trade you are proposing. Over a two year period you certainly will catch a vol explosion sooner or later and all the premium you take over the next 24 months will more then pay for the leap 2 times over.

So I guess I come back to my original question which is what exactly are you trying to do here?

 

[MDCigan]

Quote from Maverick74:



OK, I have to ask this. what exactly are you trying to do? This trade does not have that much upside and the purpose of calendars is to capture time decay on the front month position. By selling an 05 leap and buying an 06 there is no time decay and almost no difference between the two legs. There really is no edge in doing this trade. Long calendars are worthless if you are not earning any time premium on them. And I really am not sure your idea of legging into them is very good. If you want to do a leap trade. Buy the jan 06 and sell front month every month for the next 24 months and earn the premium. And since you are long vega on the back month you have unlimited upside on the vol. This would make you 100 times as much money as the trade you are proposing. Over a two year period you certainly will catch a vol explosion sooner or later and all the premium you take over the next 24 months will more then pay for the leap 2 times over.

So I guess I come back to my original question which is what exactly are you trying to do here?

Hey Mav,

Majorly delayed response here, but I wanted to respond because either you misunderstood what I am trying to do or I am missing something big-time.

What am I trying to do? In a nutshell, I am making a LONG-TERM directional bet and attempting to do it in a manner that has MINIMAL to ZERO downside risk with the possibility of very large profits at my price target with a very wide profit zone around the price target, and that has time decay WORKING FOR me instead of AGAINST me.

I think an example would be very helpful here. Let's use Newmont Mining. Let's say that 1 year from now I think Newmont Mining could be trading at $75 a share based on my fundamental and technical analysis.

Note: All option values calculated using the calculator at www.ivolatility.com

Let's say NEM pulls back to a price of 44 right around the 50 day moving average. At that price the Jan 06 LEAP call with a strike price of 75 would be 2.20. I go long that call.

Now I wait for a short-term rebound that takes the stock well above its 20 day moving average and makes it overbought. Let's say it rebounds to 50. At that price the Jan 05 75 LEAP call would be 1.65. I short that call against my Jan 06 long call.

My net risk (debit) in the trade is now 2.20 - 1.65 = .55

Fast forward to expiration day Jan 2005. Let's assume best case scenario which is NEM trading at exactly 75. The short Jan 05 75 call will have ZERO value because all time value will have dissipated. The Jan 06 75 call will be trading for 11.00 (assuming no change in implied volatility) so the spread value will be 11.00

11.00 value on a .55 debit for a total return of 1900%. That isn't too shabby in my book. I don't have my OptionVue program anymore to do P/L graphs but I suspect there is an absolutely massive profit zone around the strike price of 75 on this trade.

I see several advantages of this trade versus just plain long Jan 2006 calls.

1. Substantial reduction in capital at risk once you've legged into the short

2. Time decay working for you instead of against you

3. Much smaller upward price movement needed for position to be profitable.

The only scenario where plain long Jan 2006 calls outperform is if the stock moves upward by some absolutely astronomical amount by Jan 2005 expiration.

Here are the primary risk factors as I see it:

1. You are exposed to the net risk of the long LEAP call during the time frame in which you are waiting to leg into the short LEAP call. What if the stock doesn't rebound to provide a good entry for the short LEAP call. Ideally, you would leg into the short LEAP all at the EXACT SAME value as the long LEAP call and thus the credit received would pay entirely for the initial debit. You would have a "FREE" trade with huge upside.

2. Implied volatility declines substantially in between the time period of purchasing the long call and shorting the other one. Odds of this seem VERY, VERY remote assuming the long call is purchased at relatively low IV and the other call is shorted within a few weeks at most.

I hope that clarifies the intent of the position. It is intended more as a long-term "investment" position then any sort of short-term "trading" position to take in monthly premium.

 

[Maverick74]

Quote from MDCigan:



Hey Mav,

Majorly delayed response here, but I wanted to respond because either you misunderstood what I am trying to do or I am missing something big-time.

What am I trying to do? In a nutshell, I am making a LONG-TERM directional bet and attempting to do it in a manner that has MINIMAL to ZERO downside risk with the possibility of very large profits at my price target with a very wide profit zone around the price target, and that has time decay WORKING FOR me instead of AGAINST me.

I think an example would be very helpful here. Let's use Newmont Mining. Let's say that 1 year from now I think Newmont Mining could be trading at $75 a share based on my fundamental and technical analysis.

Note: All option values calculated using the calculator at www.ivolatility.com

Let's say NEM pulls back to a price of 44 right around the 50 day moving average. At that price the Jan 06 LEAP call with a strike price of 75 would be 2.20. I go long that call.

Now I wait for a short-term rebound that takes the stock well above its 20 day moving average and makes it overbought. Let's say it rebounds to 50. At that price the Jan 05 75 LEAP call would be 1.65. I short that call against my Jan 06 long call.

My net risk (debit) in the trade is now 2.20 - 1.65 = .55

Fast forward to expiration day Jan 2005. Let's assume best case scenario which is NEM trading at exactly 75. The short Jan 05 75 call will have ZERO value because all time value will have dissipated. The Jan 06 75 call will be trading for 11.00 (assuming no change in implied volatility) so the spread value will be 11.00

11.00 value on a .55 debit for a total return of 1900%. That isn't too shabby in my book. I don't have my OptionVue program anymore to do P/L graphs but I suspect there is an absolutely massive profit zone around the strike price of 75 on this trade.

I see several advantages of this trade versus just plain long Jan 2006 calls.

1. Substantial reduction in capital at risk once you've legged into the short

2. Time decay working for you instead of against you

3. Much smaller upward price movement needed for position to be profitable.

The only scenario where plain long Jan 2006 calls outperform is if the stock moves upward by some absolutely astronomical amount by Jan 2005 expiration.

Here are the primary risk factors as I see it:

1. You are exposed to the net risk of the long LEAP call during the time frame in which you are waiting to leg into the short LEAP call. What if the stock doesn't rebound to provide a good entry for the short LEAP call. Ideally, you would leg into the short LEAP all at the EXACT SAME value as the long LEAP call and thus the credit received would pay entirely for the initial debit. You would have a "FREE" trade with huge upside.

2. Implied volatility declines substantially in between the time period of purchasing the long call and shorting the other one. Odds of this seem VERY, VERY remote assuming the long call is purchased at relatively low IV and the other call is shorted within a few weeks at most.

I hope that clarifies the intent of the position. It is intended more as a long-term "investment" position then any sort of short-term "trading" position to take in monthly premium.

Yeah, let me offer you my thoughts on this. First of all, I'm not saying this is a bad strategy or that it won't work but rather let me dissect it here and let's see if there is a better way to do this. First of all, I have said this many times on the option threads that whenever you leg into options you are not really trading options you are trading the underlying. So any time someone comes on here and says how they leg into their positions by predicting the underlying movement then it is no longer an option play its a pure directional play on the underlying.

Having said that, let's look at this a little deeper. First of all, most of you know that the benefit of trading options over lets say just the stock is the fact that stocks move in straight lines. In other words they are linear. Options are not linear, they have curvature. It's this curvature that gives options an edge over trading the underlying because what you are really trading is the curvature of different options and that is where you make your money.

The problem you have with leaps in general and certainly trading one leap vs another leap is that there is no curvature that far out. Hence you are essentially trading an option that is rather linear which would mean you are essentially trading the stock itself. So let's examine this a little bit more closely.

The first question you ask yourself if why am I trading this leap spread over the underlying. Clearly you have a directional bias here with NEM going from 44 to 75 over the next year or two. That's a pretty sweet move. The question is, why not just buy the stock? Well the first answer you might give me is well Mav, I don't want to lay out 4400 dollars or 2200 in margin to buy 100 shares of the stock. Fair enough. But what about buying the stock synthetically? What about buying the jan 06 leap call and selling the jan 06 leap put. You are now long stock for a small cost of carry. But mav, I will have to put up the margin on the short put right? Yes you will, but only 20% of the underlying. So in this case 880 dollars. Now if we don't leg into your spread the way you suggested, that spread will not cost you 55 bucks but probably closer to 200 to 300. So there is not a big difference here and you will have no vega exposure as well.

So you pay a little more money to basically get rid of the vega exposure. And by the way, if that stock does go from 44 to 75 over the next two years, your VOL will drop! In fact it could drop hard! So by buying the stock synthetically for 880 and then the stock goes to 75 well that is a pretty sweet return. That's a $3100 profit on a $880 investment. No, its not the 1900% you eluded to earlier but you are taking a lot of risk to earn that 1900% and like I said before, that's assuming you put the spread on for $55. And to be really frank here, if you have that good of feel to trade the underlying, then you are better off trading the underlying.

Over 90% of the people on these boards are not profitable traders. This is because they cannot do precisely what you are trying to do which is basically to swing trade this position for a profit to leg into the spread. I mean seriously if you can catch 6 moves in two week periods you could make millions a year just swing trading stocks. However, most of the people on this board have a very difficult time doing just that.

So that leads to yet another possible alternative if you don't want to be long the stock or long the stock synthetically, why not just trade single stock futures. You put up very little money and if you catch a move from 44 to 75 your return on your margin will be similar to the 1900% you are trying for. Of course you say well NEM doesn't have a single stock future contract in which I would reply well, it seems that you are good at predicting these swing moves regardless of the stock so just find a single stock future that meets your technical criteria.

To briefly sum this up. LOL. This post is getting too long, there are better ways to play this and you are taking enormous risk to leg into this position. And then once you are in it there are many things that can go wrong. Time decay is not really working for you of course its not really working against you either because there is very little theta on leaps. But you will have massive vega exposure and you will take a huge hit on that if the stock goes to 75.

In fact you would be better off looking for the complete opposite trade. Look for a stock at 75 that you think will go to 44 over the long term. You have the same upside with the large move and now vega will be going in your favor. Your VOL could more then double on such a move. In fact your profits alone of the vega could make this a nice play although this won't be a pure vega play because you are spreading it but as the year goes by and you approach the front month, your vega exposure will actually increase with time as the front month leap moves closer to expiration.

Now we are talking about something interesting because now you have two things going for you, well three actually. As each month goes by your front month theta will begin working more and more for you and the back month vega will begin working more and more for you plus you have the directional component working for you. This is a much better play. But if you seek to profit from large upside moves, your better bet is to buy the long synthetic or buy a single stock future. Use the leap spreads for weak stocks that you think will tank over the next two years. There are many of these out there! Wow, this post is long. Sorry about that. Feel free to offer your thoughts on this.