Directional Calendar Spreads.

One big issue of speculating with options is time decay. You may have a solid bullish or bearish thesis on a stock and think that buying a call or a put will be a good trade, but if the market doesn't move in your favor soon and far enough, the value of you option will fall quickly with time.

I find that the best way to do a this type of speculation is a calendar spread (sell one front month option, buy a back month option) that shifts away from the current underlying price. The strike price of the calendar spread should be shifted towards the expected price move: higher for bulls and lower for bears. I like setting it up so that the Delta of the front month option to be sold is about .20 for a bullish call calendar spread, or a -.20 for a bearish put calendar spread. I prefer to use out-of-the money options for this spread, but it can be done with in-the-money options as well since the intrinsic values cancel each other.

The amount of time between the contracts also matters: the bigger the time spread the better the time decay advantage because of a higher positive theta. It also allows for more time for the market to move your way. If the market doesn't move your way by the time the front month option expires, you just sell the new front option at the same strike price.

One thing to watch out on this trade, besides a wrong directional thesis, is a fall of implied volatility. Although the spread has a reduced Vega, it is not neutral, and any change in the slope of the implied volatility term structure can affect the value of the spread before the front expiration.

Another issue is that the spread is at its maximum value at the strike price. You must unload the spread then and take your profits. Ideally it should hit the strike price at expiration, but if it gets there before that, play it safe and close it out.

Also watch out for wide bid-ask spreads. As with any spread, you are trading two or more securities as one, and each individual bid ask spread add up to a big one. It is best to look for underlying stocks with deep option markets to avoid this problem, or else you'll need patience to bid for the spread somewhere near the midpoint of the bid-ask spread.

Next week I'll write about a variation on this spread.