Chesapeake Energy Corp. (CHK: sentiment, chart, options) has drawn considerable put volume today, as the shares follow the rest of the market lower. Specifically, put volume has swelled to nearly four times CHK's daily average, with more than 17,000 of these bearishly oriented contracts changing hands so far, according to data from our Intraday Volume Explosion List. The most popular strike has been CHK's November 24 put, where some 7,800 contracts have changed hands, mostly at the bid, suggesting these contracts were sold.
After digging around in CHK's options activity, I found that this seemingly run-of-the-mill put selling activity at the November 24 strike was likely part of a more complicated spread trade on the shares. Specifically, I found that a block of 5,500 November 24 puts traded at about 9:51 a.m. Eastern time on the Chicago Board Options Exchange (CBOE) for the bid price of $0.20. At the same time, and on the same exchange, 5,500 December 24 puts changed hands for the ask price of $1.05. Given this data, it would appear that we are looking at a potential calendar spread on Chesapeake Energy Corp. This strategy is also known as a time spread, or a horizontal spread.
For those not familiar with this options strategy, a calendar spread is the simultaneous purchase and sale of an equal number of puts (or calls) on a given underlying stock at the same strike but different expiration dates. The calendar spread trader is looking for accelerated erosion in the time value of the front-month option, which he hopes to close at expiration for practically nothing, while collecting a larger premium by selling to close the back-month option.
The Anatomy of a Chesapeake Energy Calendar Spread
Drilling down on today's CHK calendar spread, the trader sold 5,500 November 24 puts for $110,000 -- ($0.20 * 100) * 5,500= $110,000. At the same time, the trader purchased 5,500 December 24 puts for $577,500 -- ($1.05 * 100) * 5,500 = $577,500. The total outlay for this position would be $467,500 -- $577,500 - $110,000 = $467,500.
The maximum loss on this trade is limited to the net debit of $0.85, or $85 per contract, paid when the trade was established. Meanwhile, the maximum profit is limited to the premium received for the back-month option when it is sold to close out the position, minus the cost to buy back the front-month put, minus the net debit paid to establish the position. The maximum profit is achieved if CHK closes at $24 per share on November expiration.
Since there are two expiration dates for this trade, and we cannot know for certain what the exact value of the December 24 put will be when the November 24 put expires, we can only estimate the approximate return on the CHK calendar spread. In the best-case scenario, CHK would close at the 24 strike when November options expire, allowing the November 24 put to expire worthless. At that point, the December 24 put would be worth only its time value and implied volatility -- no intrinsic value.
In this example, the December 24 put will be worth an estimated $1.46 at November expiration, according to IVolatility.com's pricing calculator, allowing the trader to sell to close the position for $1.46 per contract. After subtracting out the cost of the position ($0.85), the trader would snag a profit of $0.61, or $61 per contract. Below is a chart for a rough visual representation:
Implied Volatility
The most ideal calendar-spread trade occurs when near-month implied volatilities are high relative to options with a longer life. Optimally, the spread trader needs implied volatility to remain steady on the shorter-term sold option (or to increase on the purchased option). The best-case scenario for a calendar spread is that the sold option expires out of the money, while the purchased option retains time premium. At the time of the trade, implieds for the CHK November 24 put arrived at 47.50%, while the implied volatility for the December 24 put rested at 46%.
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