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Thursday November 20, 2008 |
Advanced Strategies for Options -
Horizontal Spreads - Delta Neutral Calendar Spread
As you might imagine there are many ways to construct a
calendar spread. Believe
it or not one of the more popular types of ratio calendar spread
is the Delta Neutral Calendar spread.
This
type of ratio calendar spread uses the delta’s of the calls
involved to construct a more accurate ratio. The spread can be created with either out-of-the money or
in-the-money calls but the key is for this spread to be absolutely
neutral, that is the investor should be able to earn a small
profit with very minimal risk under most circumstances. This strategy is often used by professional's at large
hedge funds.
For
the purposes of illustration we will construct two Delta Neutral
Calendar spreads using naked calls and extra long calls.
Example
#1
Suppose
Chase Manhattan (CMB) is trading at $50 and Dale is considering
using the January 55 call and the February 55 call to establish a
ratio calendar spread. Dale
determines that the deltas for these calls are 0.25 and 0.15
respectively. With that information Dale decides to construct a delta
neutral ratio spread. To
make this spread neutral Dale divides the near month call delta by
the distant month call delta (0.25/0.15) to achieve a ratio of
1.667. In other words
to make the ratio spread neutral Dale is required to sell 1.667 as
many of the January 55 calls as the number of February 55 calls he
purchases. To make
matters simple Dale sells 10 January 55 calls at $1.50 per contract
and buys 6 contracts of the CMB February 55 calls at $2 per
contract. The net
credit for this transaction is $300.
All
things being equal the probability of profit for this transaction
is extremely high with very limited risk. Dale will need to monitor CMB stock to make certain the
stock does not move into the money ahead of the January
expiration.
Example
#2
As
mentioned above this strategy can be constructed with both
out-of-the money and in-the-money calls. Once again with Chase Manhattan (CMB) stock trading at $50
Dale decides to construct a delta neutral ratio spread. This time Dale chooses to use the January 45 and February
45 calls. Dale determines the deltas for these options to be 0.8 and
0.7 respectively. You
will note that in the case of in-the-money calls the shorter-term
call has a higher delta than the longer-term call. To determine the ratio of the calendar spread Dale divides
the distant month call delta by the delta of the near month call
(0.7/0.8). The
neutral ratio for this in-the-money spread is .875 to 1. That is Dale
must sell .875 of the January call for each one of
the February calls purchased. With the January 45 calls trading at $5.50, Dale sells 7
contracts for net proceeds of $3,850 and simultaneously buys 8
contracts of the February 45 call at $6 per contract for a net
cost of $4,800. The net debit for this transaction is $950.
Once
again this delta neutral ratio spread should yield a small profit
with a high degree of probability.
At
first glance it would be easy to dismiss the delta neutral
strategy using in-the-money calls because this position is
established for a net debit. But in-the-money calls have a distinct advantage. First there is no upside risk should the stock rise
dramatically because the additional long calls would more than
offset the loss for the short calls. Second if the underlying common stock remains at the
same price the spread would still make money because the loss in
time value for the additional long calls would be more than offset
by the spread calls. The
only fly in the ointment for this transaction is a precipitous
drop for the underlying common stock. In this event some defensive action must be taken but even
in this case the loss is limited to the initial net debit.
Summary:
1. Delta spreads are neutral.
2. The correct ratio to use in a delta spread is
determined by dividing the delta of the purchased call by the
delta of the written call.
3. It’s important that the ratio of the delta spread
not be too large, an absolute limit such as 4 to 1 can be placed
on all spread candidates.
4. The ratio should not be too small for example if
the ratio is 6 to 5 it should probably be rejected.
5. If delta neutral spread is established with
out-of-the money calls a net credit will occur.
6. If the delta neutral spread is established with
in-the-money calls a net debit will occur.
bullish
calendar spread 
ratio calendar spread
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Horizontal Spreads > Delta
Neutral Calendar Spread
