Wednesday, October 19, 2011

Analyzing The Unlikely Calendar

One of the points I assert about rolling short options is that an option with more time on it almost always trades for a higher price, thus, you can almost always roll-out almost any short option for a credit. To see that this must be so you can consider the implications of the opposite: the front month trading for a higher price than the back month. I claim that this is the equivalent of the market giving away riskless trades in the form of credit-calendars (i.e. selling a front month option and purchasing the same strike option with more time to expiration.) The Analyze tab of the ThinkDesktop trading platform gives one a way to visualize this by plotting the profit/loss graph for such a trade:



So here I contemplate an unlikely calender: selling the SPY Nov 123 Call while simultaneously buying the SPY Dec 123 Call for a credit of 10 cents. This trade always produces a profit even when the underlying price moves very far away from the current price (~122.25) Notice that if SPY closes anywhere in the 68% probability range (light blue shaded area) on expiration you will realize some nice gains whereby a $10 credit increases to a profit from $50 to $350 (red line.) Such situations will quickly be traded out of existance by electronic arbitrageurs, and probably the market maker will lose his job because these only ever come about by error.

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