We received a few questions on the workings of a calendar spread like the one we just closed in MNST. I wanted to take the time to explain how this structure works as it’s a great lesson in how options work in general.
We initiated the trade in MNST because we were bearish in the name going into earnings, but didn’t like the implied move the options market was pricing in. Essentially, if you wanted to bet on a down or up move, you had to pay pretty rich premiums in order to do so. The ATM straddle in August was pricing about an 8 dollar move. Here’s what we said in the original post:
Volatility: Implied vol is sky high going into earnings, with the average implied vol across all months the highest it’s been in recent history. The ATM straddle in August is around 8 dollars, which is close to 100 vol. September vol is in the mid 50′s and is likely to fall into the 30′s or 40′s following earnings, depending on the size of the stock’s move.
August options are much higher than out months with skew high to the downside.
So what we decided on was a structure where we took advantage of sky high August vol by selling it, and thereby financing a much lower vol September put. The stock complied by going down to the low 60’s following earnings, and down even more today on legal troubles.
The best way to understand why the calendar makes sense is that the two months are not in sync. When the stock goes down following the event, the two different puts react differently even though they are the same strike. What happens in a situation like this is the August puts, which went out at near 110 volatility, get lowered dramatically (to the 40s) while the Sept puts get lowered from only 65 vol down to the 40’s. So what you’ll have is a vol collapse in the near month that is greater than the next month. So in a structure like this where the stock moves within its implied move, it’s entirely conceivable that the August puts will go down in price (even with the stock down 10%) while the September puts go up in price. This sets up a number of interesting opportunities to take money off the table either entirely or with an eye to further weakness by adjusting the position while booking some profits.
Our original plan, after the stock settled in the low 60’s yesterday, was to wait for the August puts to decay to next to nothing, then cover them before next Friday and sell a downside put in September, turning the structure into a September put spread that was financed with all that decayed August premium. Little did we know that another gap was coming on news of a state AG investigating their top product. As a result, we were worried that below 57.5, we’d start to lose our nice little profit.
The reason the trade starts to lose money as it goes lower through the strike is that the delta of the trade structure changes. This morning, the structure actually had a delta of +5, as opposed to the short delta structure it closed with last night.
The best way to picture this is by taking the stock down to an extreme, say, 40 dollars. What happens there is the August puts and the September puts both start trading at parity (17.50) , and you’ve now lost the 70c in premium that you originally put into the trade. If you imagine that happening tick by tick in the stock, the August puts, with only 1 week to expiration lose their premium quicker, but gain deltas faster than the September puts. Eventually both puts become 100 deltas, and you’re left with a perfectly hedged short vs long synthetic stock, and out your 70c.