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Friday, March 29, 2024

Trading The Trends

How many times have you traded stocks that you felt were oversold, but you just weren’t convinced the downtrend was over?  How many times have you seen a stock or an index drop further before hitting a bottom and racing back up again?  And how many times have you profited from such moves?

In this article, one of the many strategies that takes advantage of such expectations is discussed – the non-standard put calendar.

Before introducing the non-standard put calendar, let’s first review quickly the standard put calendar. In a standard Put Calendar, a long put option is purchased out-of-the-money, typically with 45-120 days of time value and a short put option is sold at the same strike price in the current month (expiration month).

The expectation when entering a put calendar is that a stock will remain relatively flat or ideally will drop a little in price.  If the stock were to fall to – but not below – the strike price of the put options by expiration, then the short put would expire worthless and the long put would gain in value.  Hence, both options would produce a profit. 

More often than not, you will find when buying one option and selling another, that only one of the two options makes money.  While this may be true also for the put calendar, if the stock remains flat (resulting in some loss in the long option due to time-decay and a profit in the short option as it expires worthless) or if the stock rises (in which case the long put loses value due to stock appreciation while the short put profits in such instances), the strategy offers the potential to make outstanding percentage returns if the stock should fall slightly.

The standard put calendar is structured such that the long put always protects the short put in the event that a sharp decline in stock price materializes.  This is due to the fact that the long put is placed further out in time.  The worst-case condition for a put calendar is that a stock moves up or down by a huge margin before we can take any action to modify the structure of the trade to the new trend.  In short, gaps up or down are going to work completely against the strategy and much of the debit spent on the overall position is in jeopardy at such times.

While the standard put calendar is limited by gaps, the non-standard put calendar can profit on these occasions.  As with any strategy, other tradeoffs must be considered, which we willl discuss later in this article.

In a non-standard put calendar, the timeframe of the long and short put options is reversed.  So, the short put is placed further out in time while the long put is placed in a month closer to expiration – usually the current month or the second month to expiration.

For example, let’s say we do a little fundamental research on CROX and discover the stock is trading with a forward multiple of 5, yet analysts project growth this year of 35% and next year of 20% (source:  Yahoo! Finance).  Indeed, we discover that many analysts have target prices that are 3-4 times the current stock price, $17.18.  Further, we discover the company has an oustanding Return on Equity, 51% and a low PEG of 0.27.

But technically, the stock chart of CROX is bearish; the stock has dropped over 50% since the beginning of the year.  We may be somewhat reluctant to enter a gung-ho bullish position that conflicts with the current trend and yet we may have a sense that the end of the bearish trend is near. 

In short, we may have an expectation from our technical research that the stock could drop lower, but our fundamental research tells us when the stock pops, it could pop substantially!  There are many strategies we could employ but the one we will consider here is the non-standard put calendar.

An application of the non-standard put calendar on CROX comprises selling to open the May strike 15 short put for $1.50 and buying to open the April strike 15 long put for $0.60.  Hence, the net credit in the trade is $0.90. 

Now let’s think about the trends that caused us trouble in the standard put calendar – big moves up or down!  If we consider the worst-case outcome – that the stock drops to zero – the obligation of the short put option is to purchase shares at strike 15.  However, we get to keep $1.50 for entering that contract.  We also have the right to sell stock at strike 15 because we hold the long put option.  If we assume the we end up offsetting the assignment of the short put with the long put exercise, hence buying and selling the stock at $15, then the net result from a stock perspective is negligible – no gain or loss (other than commissions and bid-ask spreads).  From an options perspective, we get to keep $1.50 from the short put assignment but we lose $0.60 from the long put exercise, hence we get to keep $0.90 overall!

Now what happens if the stock rises substantially?  In that event both options would ultimately expire worthless and, because the short put offered more premium than the long put cost, the overall trade would produce a credit of $0.90 for us. 

In fact, we will find whatever trend we consider relatively favorable.  But there is a catch!  We must be aware that the long put expires prior to the short put.  So, if the stock is hovering near the strike price of both options when the long put  expires and if an earnings announcement is due prior to expiration of the short put option – as is the case with CROX – then conservative traders may wish to choose a variant on this strategy.  Stock and Option Trades members may take a look at this week’s Trade Alert Summary section to learn how we deal with such situations.  Also note that margin requirements are greater when choosing the non-standard put calendar versus the standard put calendar.  Brokers tend to have different margin requirements for this strategy so make sure to verify what stipulations are in place before considering such a position.

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