The Platinum Pro Spread Channel tool can be used to scan for spreads and calendars with a variety of user-defined wizard settings. These settings allow traders to identify a specific directional bent (bullish or bearish) or to use channel settings to using the "Force Channel to be Inside Profit Zone" selection. As with other scanning tools, the Spread Channel allows sorting by IV Skew, Max Profit/Loss and Probability of Profit [PoP].

A Spread Channel scan was completed using the S&P 100 optionable stocks on October 21st after the close using the settings provided in Figure 1. It's important to note that the scan was set-up in a way that allowed both standard spreads (single expiration month) and calendar spreads (two expiration months). To accomplish this, the "Force Channel to be Inside Profit Zone" selection was also used.

Since the scan allows for different types of strategies, the sorted results do not represent an apples-to-apples comparison. The bottom line; however, is that a nice list of potential strategies will appear for review. One position selected for assessment is a Microsoft (MSFT) Nov-Dec put diagonal spread. Although this was ranked 14th by Profit/Loss % and 13th by PoP, it reports earnings before the open this Friday (10/23/09), which allows for monitoring of the 8.31% skew in place at the close Wednesday.

The position Profit/Loss % is estimated at 60 - profit of $52 versus a risk of $86 - and the PoP at the nearer term expiration is estimated at 81.5%. Given two expiration months, the trader should consider the potential risk-reward at the nearer month and after that date. Figures 2 & 3 provide the position information and risk-reward data which is calculated using an estimated value for the longer-term, long option. The trader is alerted to this by a bold, blue font used in Platinum to display Max Profit, Max Risk and Breakeven data.

Figure 1: Spread Channel Scan
click here for larger view

Figures 2 & 3: MSFT Put Diagonal Position and Risk Data

The remaining portion of this article looks at the risk-reward picture immediately prior to expiration of the short option and right after it.

First Risk-Reward Date

In the sample provided, the MSFT short put alone will lose money at November expiration if the stock is trading below the 26 strike price by more than the $0.12 credit, or at $25.88. To estimate the breakeven of 25.17 for the combined position, a value of $0.71 is assumed for the long put. However, if MSFT is trading below 26 going into the first expiration, the short option will likely be assigned over the weekend.

Assuming MSFT is above 26 on the Friday immediately prior to expiration, the short option should expire worthless and the long option will have some extrinsic value. Even if MSFT is close to $26.00 at expiration, there is relatively small risk in allowing the option to expire since it is covered by the long put.

Assuming MSFT is below 26 on that Friday; the trader has a few alternatives:

1. Buy the short put to close the leg, avoiding assignment, and hold the long put,
2. Close the entire position by buying the short put and selling the long put, or
3. Wait to see what happens over expiration weekend.

Not being a fan of passive trade management, only the first alternative is addressed next. Figure 4 provides the risk graph for the combined position on Wed, October 21st. A sideways channel stress test was used since visual inspection shows no apparent downward channel and continued upward movement for MSFT minimally allows for the initial credit of $12.

Figure 4: MSFT Put Diagonal Risk Graph

Risk-Reward after the First Expiration

It's pretty safe to assume that if the long strike is out of the money by less than $1 (MSFT < $26), it will have some extrinsic value with 28 days remaining to expiration. The worst case scenario when the short option is in the money and the long option is out of the money occurs when MSFT closes at $25.00. Assuming the short option is closed at $1.00, the position now represents a debit of $88.00 ($100 cost minus the initial credit of $12). While there is still some extrinsic value remaining for the long put, time decay is accelerating at this point. In the event the long option is held to the second expiration and MSFT remains at $25.00 or higher, the max loss will be realized.

It's almost as if the trader buys a long, next month put for $0.88 immediately after expiration. The risk graph would then display an increasing position value below the new breakeven level of $24.12 for MSFT. Below this price, profits can technically accumulate to $2,412 if MSFT goes to 0 by the December expiration. Between $24.13 and $25, the risk increases from 0 all the way to the max risk of $88.

If for some reason your exit was not triggered prior to the first expiration, something that can help with the "to sell or not to sell" decision is considering whether you would create the same position as a new trade if you didn't currently hold it on your account. Assuming you would not purchase a long, next month option that was out of the money, this approach would prompt you to close the long position immediately after the first expiration. A better approach would include mapping out the entire trade prior to entry, which would prompt both price and time exits.

This sample strategy provides another use of channel tools with some additional considerations for the risk graph. As always, it's for you to decide whether a tool or strategy suits your style, but there's definitely some benefit to tracking potential trades when exploring either one which may be new to you. You may want to track the position in Platinum and note how changing skews impact it over the short-term and how price and time impact it over the long-term. Also monitor any channel changes that occur along the way.

Clare White
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site
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