Annaly Capital Management Inc. (NLY: sentiment, chart, options) has drawn considerable put volume today, despite a relative lack of movement from the equity. Specifically, put volume has swelled to more than four times NLY's daily average, with more than 5,200 of these bearishly oriented contracts changing hands so far, according to data from our Intraday Volume Explosion List. The most popular strikes have been NLY's September 16 and October 16 puts, which have each seen roughly 2,000 contracts change hands.
Drilling down on this activity, I found that eight blocks of September 16 puts, totaling 1,500 contracts, traded at about 10:00 a.m. Eastern time on the International Securities Exchange (ISE) for the bid price of $0.08. At the same time, and on the same exchange, 1,500 October 16 puts changed hands for the ask price of $0.28. Given this data, it would appear that we are looking at a potential calendar spread on Annaly Capital Management. 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 an Annaly Capital Management Calendar Spread
Drilling down on today's NLY calendar spread, the trader sold 1,500 September 16 puts for $12,000 -- ($0.08 * 100) * 1,500 = $12,000. At the same time, the trader purchased 1,500 October 16 puts for $42,000 -- ($0.28 * 100) * 1,500 = $42,000. The total outlay for this position would be $30,000 -- $42,000 - $12,000 = $30,000.
The maximum loss on this trade is limited to the net debit of $0.20, or $20 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. This maximum profit is achieved, in this particular trade, when NLY closes at $16 per share on Friday, Sept. 18.
Since there are two expiration dates for this trade, and we cannot know for certain the exact value of the October 16 put when the September 16 put expires, we can only estimate the approximate return on the NLY calendar spread. In the best-case scenario, NLY would close at the 16 strike when September options expire, allowing the September 16 put to expire worthless. At that point, the October 16 put would have only time value and implied volatility to its value -- no intrinsic value.
In this example, the October 16 put will be worth an estimated $0.48 at September expiration, according to IVolatility.com's pricing calculator, allowing the trader to sell to close the position for $48 per contract. After subtracting out the cost of the position ($0.20), the trader would snag a profit of $0.28, or $28 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 moment, implieds for the NLY September 16 put arrive at 26%, while the implied volatility for the October 16 put rests at 31%. For comparison, the stock's one-month historical volatility arrives at 20.41%, while the two-month historicals sit at 20.63%.
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