21 Jul 2020

What is a Long Jelly Roll?

A long jelly roll is an option strategy that aims to profit from a form of arbitrage based on option pricing. The jelly roll looks for a difference between the pricing of a horizontal spread (also called a calendar spread) composed of call options at a given strike price and the same horizontal spread with the same strike price composed of put options.

Key Takeaways

  • A long jelly roll is an option spread-trading strategy that exploits price differences in horizontal spreads.
  • The strategy includes buying a long calendar call spread and selling a short calendar put spread.
  • The two spreads in this strategy are usually priced so close together that there is not enough profit to be made to justify implementing it.

How a Long Jelly Roll Spread Trade Works

A long jelly roll is a complex spread strategy that positions the spread as neutral, fully hedged, in relation to the directional movement of the share price so that the trade can instead profit from the difference in purchase price of those spreads.

This is possible because horizontal spreads made up of call options should be priced the same as a horizontal spread made up of put options, with the exception that the put option should have the dividend payout and interest cost subtracted from the price. So the price of the call spread should typically be a bit higher than the price of the put spread—how much higher depends on whether a dividend payout will occur before expiration.

Constructing a Jelly Roll Spread Trade

A jelly roll is created from the combination of two horizontal spreads. The spread can be constructed as a long spread, meaning the call spread was bought and the put spread was sold, or as a short spread, where the put spread is bought and the call spread is sold. The strategy calls for buying the cheaper spread and selling the longer spread. In theory, the profit comes when the trader gets to keep the difference between the two spreads.

For retail traders, the transaction costs would likely make this trade unprofitable, since the price difference is rarely more than a few cents. But occasionally a few exceptions may occur making an easy profit possible for the astute trader.

Long Jelly Roll Construction

Consider the following example of when a trader would want to construct a long jelly roll spread. Suppose that on January 8th during normal market hours, Amazon stock shares (AMZN) were then trading around $1,700.00 per share. Suppose also the following January 15th/January 22nd call and put spreads (with weekly expiration dates) were available to retail buyers for the $1700 strike price:

Spread 1: Jan 15 call (short) / Jan 22 call (long); price = 9.75

Spread 2: Jan 15 put (short) / Jan 22 put (long); price = 10.75

If a trader is able to buy Spread 1 and Spread 2 at these prices, then they can lock in a profit because they have effectively purchased a long position in the stock at 9.75 and a short position in the stock at 10.75. This happens because the long call and the short put position create a synthetic stock position that acts very much like holding shares. Conversely, the remaining short call position and long put position create a synthetic short stock position.

Now the net effect becomes clear because it can be shown that the trader initiated a calendar trade with the ability to enter the stock at $1,700 and exit the stock at $1,700. The positions cancel each other out leaving only difference between the option spread prices to be a concern that matters.

If the call horizontal spread can actually be acquired for one dollar less than the put option, then the trader can lock in $1 per share per contract. So a 10 contract position would net $1,000.

Short Jelly Roll Construction

In the short jelly roll the trader uses a short call horizontal spread with a long put horizontal spread—the opposite of the long construction. The spreads are constructed with same horizontal spread methodology but the trader is looking for the call spread pricing to be much lower than the put spread. If such a price mismatch were to occur that is not explained by upcoming dividend payments or interest costs, then the trade would be desirable.

Variations on the Jelly Roll Spread Trade

This strategy can be approached by implementing a variety of modifications including increasing the number of long positions on one or both of the horizontal spreads. The strike prices can also be varied for each of the two spreads, but any such modification creates additional risks to the trade.

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