A calendar spread is a trade that can be used when the trader expects a gradual or sideways move in the stock. Sometimes called the horizontal spread, it uses two options with the same strike prices and different expiration dates. It can be created with puts or calls. Generally, with the calendar spread, the option strategist is buying a longer-term option and selling a shorter-term option. 

Unlike the vertical spreads like bull call spreads, bear put spreads, and other trades that are directional in nature (i.e., they require the shares to move higher or lower), calendar spreads can be created when the strategist is neutral on the shares. Basically, in a neutral calendar spread, the trader wants the short-term option to decay at a faster rate than the long-term option. However, strategists can also create both bullish and bearish calendar spreads depending on their outlook for the shares.

Calendar Spread Mechanics

Let’s consider an example of the calendar spread using XYZ at $50 a share in March. In this case, we expect the shares to stay at roughly the same levels or move modestly higher. Consequently, we decide to purchase a LEAPS long-term option and offset some of the cost of that option with the sale of a shorter-term option. In this case, we buy the XYZ 60 LEAPS at $4 and sell an XYZ 60 call with two months of life remaining at $1. The cost of the trade is $300 [(4 – 1) × 100 = $300], which is also the maximum risk associated with this trade. The maximum profit is unlimited once the short-term option expires. At that point, the trade is simply a long call.

Prior to the expiration of the short call, the maximum profit and breakeven will depend on a number of factors including volatility, the stock price, and the amount of time decay suffered by the long call. Basically, it is impossible to determine how much value the long call will gain or lose during the life of the short option. Options trading software, such as the Platinum site, can help give a better sense of the risk, rewards, and breakevens associated with any particular calendar spread. For now, suffice it to say that the risk is limited to the net debit. In addition, time decay is not linear. That is, an option with 30 days until expiration will lose value more rapidly than an option with six months until expiration. 

Calendar spreads attempt to take advantage of the fact that short-term options suffer time decay at a faster rate than long-term options. Computing breakeven prices for complex trades requires the use of computer software. To understand why, let’s consider a bullish calendar spread. In this case, we are buying a longer-term call and selling a shorter-term call with the same strike price. The trade is placed for a debit and closed for a credit. Ideally, the short-term call will expire worthless, but the longer-term call will retain most or all of its value. In that case, we can sell another call or close the trade at a profit. The breakeven price for the calendar spread will depend on the value of the long call when the short option expires. 

The value of the long call will, in turn, depend on several factors. Say, for example, the stock price falls and the short call expires worthless. The long-term option might still have value, but we don’t know exactly how much value because of changes in implied volatility and time decay. To break even, the value of the long call when it is sold must be equal to the debit paid for the calendar spread. If the call is worth more, and the spread is closed when the short option expires, the trade yields a profit. However, it is impossible to calculate the exact value of the long call, and therefore, the breakeven when the short call expires. It is possible to get an idea or rough guess, but it is better to use computer software to plot the risk graph and see where the potential breakeven points might be.

Exiting the Position

The exit strategy for the calendar spread is extremely important in determining the trade’s success. Specifically, if the shares remain range-bound and the short call expires worthless, the strategist must make a decision: (1) to exit the position, (2) to sell another call, or (3) to roll up to another strike price. Generally, if the shares are stable as anticipated, the best approach is to sell another shorter-term option. In our example, the long call has 18 months until expiration and was purchased for $4. A call with three months can be sold for $1. If, over the course of 18 months, calls with three months until expiration can be sold for $1 five times, the credit received from selling those calls totals $5. 

The cost of the long option is only $4. Therefore, the trade yields a $1 profit on a $4 investment, or 25 percent over the course of 15 months. Furthermore, after 15 months, the long call, which has been fully paid for, will still have three months of life remaining and can offer upside rewards in case XYZ marches higher. Sometimes, however, it is not possible to sell another call. Instead, the share price jumps too high and the risk profile associated with selling another call is not attractive. In that case, the strategist might simply want to close the position by selling the long call. Or another calendar spread can be established on the same shares by rolling up to a higher strike price. 

In that case, the strategist closes the long call, buys back another long call with a higher strike price, and then sells a shorter-term call with the same strike price. If the shares move against the strategist during the life of the short call, the best approach is probably to exit the entire position once the short call has little time value remaining. If the shares jump higher and the long call has significant time value, it is better to close the position rather than face assignment or buy back the short option. If assigned and forced to exercise the long option to cover the assignment, the strategist will lose the time value still left in the long contract.

Calendar Spread Case Study

Shares of Johnson & Johnson (JNJ) are trading for $51.75 during the month of February and the strategist expects the shares to make a move higher. A bullish calendar spread is created by purchasing a JNJ January 2005 60 call for $4 and selling an April 2003 60 call for $1. The trade costs $300: (4 – 1) × 100 = $300. Therefore, the initial debit in the account is equal to $300. The debit is also the maximum risk associated with this trade. As the price of the shares rises, the trade makes money. As we can see from the risk, the maximum profit occurs when the shares reach $60 at April expiration and is equal to roughly $570. At that point, the short call expires worthless, but the long call has appreciated in value and can be sold at a profit. 

If the strategist elects to hold the long call instead, another calendar spread can be established by selling a shorter-term call. At that point, the risk curve will probably look different. The downside breakeven is 46.80. Below that, the trade begins to lose money. An options trading software program like Platinum can be used to compute the maximum gain and the breakevens. In this case study, the stock did indeed move in the desired direction. By April expiration, shares of JNJ fetched $55.35 a share. At that point, the short call would expire worthless and the strategist would keep the entire premium received for selling the April 60 call. 

FIGURE  JNJ Calendar Spread 

Meanwhile, the January 60 call has not only retained all of its value, but it is currently offered for $5.10. Therefore, the strategist’s earnings are $210 of profit per spread ($1 received for the premium and $1.10 profit for the appreciation in the January 60 call), for a five-month 70 percent gain. On the other hand, the strategist could also hold the long call and sell another short-term call with the same or higher strike price. If the strategist chooses to sell a call with a higher strike price, the position becomes a diagonal spread.


As we have seen, calendar spreads are trades that involve the purchase and sale of options on the same shares, with the same strike price, but different expiration dates. One thing to look for when searching for calendar spreads is a volatility skew. A volatility skew is created when one or more options have a seeable difference in implied volatility (IV). Implied volatility is a factor that contributes to an option’s price. All else being equal, an option with high IV is more expensive than an option with low IV. In addition, two options on the same underlying asset can sometimes have dramatically different levels of volatility. When this happens, it is known as volatility skew. Looking at various quotes of options and looking at each option’s IV will reveal potential volatility skews. 

As previously mentioned, there are two types of volatility skews present in today’s markets: volatility price skews and volatility time skews. Volatility price skews exist when two options with the same expiration date have very different levels of implied volatility. For example, if XYZ is trading at $50, the XYZ March 55 call has an implied volatility of 80 percent and the XYZ March 60 call has implied volatility of only 40 percent. Sometimes this happens when there is strong demand for short-term at-the-money or near-the-money call (due to takeover rumors, an earnings report, management shake-up, etc.). In that case, the 55 calls have become much more expensive (higher IV) than the 60 calls. Calendar spreads can be used to take advantage of the other type of volatility skew: time skews. 

This type of skew exists when two options on the same underlying asset with the same strike prices have different levels of implied volatility. For example, in January, the XYZ April 60 call has implied volatility of 80 percent and the XYZ December 60 call has implied volatility of only 40 percent. In that case, the short-term option is more expensive relative to the long-term call and the calendar spread becomes more appealing (although the premium will still be greater for the long call because there will be less time value in the short-term option). The idea is for the strategist to get more premiums for selling the option with the higher IV than he or she is paying for the option with the low IV.


There are a significant number of different ways to structure diagonal spreads. Diagonal spreads include two options with different expiration dates and different strike prices. For example, buying a longer-term call option and selling a shorter-term call option with a higher strike price can be a way of betting on a rise in the price of the shares. The idea would be for the shares to rise and cause the long-term option to increase in value. The short-term call option, which is sold to offset the cost of the long-term option, will also increase in value. 

But if the shares stay below the short strike price, the short option expires worthless. In this type of trade, the longer-term option should have some intrinsic or real value, but the option sold should have only about 30 days or so to expiration and consist of nothing but time value. This strategy profits if the shares make a gradual rise. Similar diagonal spreads can be structured with puts and generate profits if the shares fall.

Diagonal Spread Example

Diagonal spreads are a common way of taking advantage of volatility skews. Let’s consider an example to see how. The rumor mill is churning and there is talk that XYZ is going to be the subject of a hostile takeover. With shares trading at $50 a share, the rumor is that XYZ will be purchased for $60 a share. At this point, you have done a lot of research on XYZ and you believe that the rumor is bogus. Furthermore, you notice that the talk has created a time volatility skew between the short-term and the long-term options. In this case, the March 55 call has seen a jump in implied volatility to 100 percent and trades for $1.50. Meanwhile, the December contract has seen no change in IV and the December 50 call currently trades for $6.50.

To take advantage of this skew, the strategist sets up a diagonal spread by purchasing the December 50 call and selling the March 55 call. The idea is for the short call to lose value due to time decay and a drop in implied volatility. Meanwhile, the long-term option will retain most of its value. The cost of the trade is $5 a contract or $500: (6.50 – 1.50) × 100. This is the maximum risk associated with the trade. There are no hard-and-fast rules for computing breakevens and maximum profits for diagonal spreads. In our example, the ideal scenario would be for the short option to lose value much faster than the long option due to both falling IV and time decay. However, the term diagonal spread refers to any trade that combines different strike prices and different expiration dates. Therefore, the potential combinations are vast. 

Exiting the Position

The same principles that were discussed with respect to calendar spreads apply to diagonal spreads. If the shares move dramatically higher, the short option has a greater chance of assignment when it moves in-the-money and time decay diminishes to a quarter of a point or less. If the long call has significant time value, it is better to close the position than face assignment. If assigned and forced to exercise the long option, the strategist will lose the time value still left in the long contract. If the short option expires as anticipated, the strategist can close the position, roll up to a higher strike price, or simply hold on to the long call.

In the previous example, a diagonal spread was designed to take advantage of a volatility skew. Once the skew has disappeared and the objective is achieved the strategist can exit the position by selling the long call and buying back the short call. However, it generally takes a relatively large volatility skew in order to profit from changes in implied volatility alone. Therefore, strategists generally use time decay to their advantage as well, which, as we saw earlier, impacts shorter-term options to a greater degree than longer-term options.

In the example, the idea was to take in the expensive (high IV) premium of the short option and benefit from time decay. As a result, once the short option expires, there is no reason to keep the long option. Thus, selling an identical call can close the position. If the shares fall sharply, the trade will lose value and the strategist wants to begin thinking about mitigating losses. A sharp move higher could result in assignment on the short call as expiration approaches. Again, it is better to close the position than face assignment because the long option will still have considerable time value, which would be lost if the long call is exercised to cover the short call.

Breakeven Conundrums

While the risk to the diagonal spread is easy to compute because it is limited to the net debit paid, and the reward is known in advance because it is unlimited after the short-term option expires, the breakeven point is a bit more difficult to calculate. Often, traders first look at the breakeven price when the short-term option expires. However, at that point in time, the longer-term option will probably still have value. In addition, the value of that long option will be difficult to predict ahead of time due to changes in implied volatility and the impact of time decay. For example, assume we set up a diagonal spread on XYZ when it is trading for $53 a share. We buy a long-term call option with a strike price of 60 for $3 and sell a shorter-term call with a strike price of 55 for $1. 

The net debit is $200. Now, let’s assume that at the first expiration the stock is trading for $54.75 and the short-term option expires worthless. How much is the longer-term option worth, and what is the breakeven? It is difficult to predict what the longer-term option will be worth because of the impact of time decay and changes in implied volatility. So, it is impossible to know the breakeven when the short-term option expires because it will also depend on the future value of the longer-term option. If the longer-term option has appreciated enough to cover the cost of the debit when the short-term option expires, the trade breaks even. After the short-term option expires, the breakeven shifts to the expiration of the longer-term option. 

In this case, the breakeven price becomes the debit plus the strike price, or $62 a share. However, the breakeven will change again if we take follow-up action like selling another short-term call option. In sum, it is difficult to know exactly what the breakeven stock price will be for the diagonal or calendar spread because we are dealing with options with different expiration dates. In these situations, the best approach is to use options-trading software to get a general idea. However, even software is not perfect because it can’t predict future changes in an option’s future implied volatility. The best we can do is to calculate an approximate breakeven and then plan our exit strategies accordingly.

Diagonal Spread Case Study

For the diagonal spread case study, let’s consider Johnson & Johnson (JNJ) trading for $51.75 a share in early February 2003. The strategist sets up a diagonal spread by purchasing a January 2005 50 call for $6.50 and selling the March 2003 55 call for $1.50. Again, there is time volatility skew when purchasing these contracts and the long call has lower IV compared to the short call. This type of time volatility skew is a favorable characteristic when setting up this type of diagonal spread. The risk, profit, and breakevens for this trade are relatively straight-forward. The cost of the trade is $500 and is equal to the premium of the long call minus the short call times 100: [(6.50 – 1.50) × 100]. 

The debit is also the maximum risk associated with this trade. Profits arise if the shares move higher. The maximum profit during the life of the short call equals $374.45. After the short call expires, the position is no longer a diagonal spread. It is simply a long call. At that point, the strategist can sell, exercise, or hold the long call. It is similar to the calendar spread. In both cases, the strategist wants the share price to move higher, but not rise above the strike price of the short call. A move lower will result in losses. If the stock rises and equals $55 a share at the March expiration, the short call will expire worthless. 

The strategist will keep the premium received from selling the short call and will have a profit from an increase in the value of the call. At that point, he or she can sell, exercise, or hold the long call. If the trader elects to hold the long call, another diagonal spread can be established by selling another shorter-term call. So, what happened with our JNJ calendar spread? Shortly after the trade was initiated, shares rallied sharply and, in the week before expiration, the stock was well above the March 55 strike price. At that point, we would be forced into follow-up action because assignment was all but assured. For example, the week just before expiration, the stock was making its move above $55 a share. 

FIGURE  JNJ Diagonal Spread 

Seeing this, the strategist would probably want to buy the short-term call to close because assignment would force him or her either to buy the stock in the market for more than $55 a share and sell it at the strike price or cover with the long call, which still has a significant amount of time value. So, facing the risk of assignment, the position is closed when the stock moves toward the strike price of the short call. The Friday before expiration, the January 2004 50 call was quoted for $8.50 bid. Therefore, the strategist would book a $2 profit on that side of the trade. At the same time, he or she would want to buy to close the short March 55 call, which was offered for $1. That side of the trade would yield a 50-cent profit. Therefore, taken together, the strategist makes $250 on a $500 investment. 

Time decay has indeed worked in this trade’s favor. The reason I like trading diagonal spreads is that they lend themselves to numerous position adjustments during the trade process. For example, say we initiate a diagonal calendar spread on stock XYZ by purchasing a longer-term ITM call option and writing a shorter-term slightly OTM call option. This position can be put on at a lower cost than the traditional covered call and with a subsequent lower risk. It also has a higher-percentage return than a covered call but still profits from time decay. However, the real advantage of the position in my view is its inherent flexibility. Consider just some of the adjustments afforded the options trader with the diagonal spread position:

• XYZ is below the strike price that we initially sold: Let it expire worthless and realize the short-term call premium as a profit. We can then exit the long position, or sell another short-term call for the next month out.
• XYZ is near or above the short strike price by the expiration date: Buy the short option back and sell back the long position to close the trade, or sell the next month calls of the same strike or even a higher strike if the underlying stock has an upward directional bias.
• XYZ is deep in-the-money: Exit the entire position and rebracket the diagonal spread at the new trading range.

In addition, we can convert from a diagonal spread to a horizontal if more than 60 days are still left until expiration. If we are going into the final 30 days of the long position we can transform this position into a vertical spread. Even though our XYZ example was created using calls, the trader can also construct this position using put options. These are just a handful of adjustments afforded the options trader when managing a diagonal spread. I encourage you to test and paper trade these types of positions. The adjustment possibilities are virtually endless and for my money that makes for a terrific options strategy.


Collar spreads are usually one of the first combination option trades a person is exposed to after getting a grasp of what basic puts and calls are all about. They are usually presented as appreciating collars or protective collars. However, not much mention is given to the inherent flexibility of this position and how, as a trader, if you want to put just a little bit more effort into the trade, you can increase your returns. There are two types of collar trades: the protective collar and the appreciating collar. The protective collar is chosen when a person already owns the stock and has a bearish outlook but still wants to hold the stock.

In this case, the trader would purchase an at-the-money put and at the same time sell an at-the-money call to finance that put. This essentially locks in the current price and protects the trade from losses until such time when the bearish scenario changes. The other type of collar is an appreciating collar. This is the one where you can make money and indeed trade dynamically if you desire. The appreciating collar involves buying stock and for every 100 shares of stock purchased buying an at-the-money put and selling an out-of-the-money call to finance the put. 

The key to this strategy is selecting a stock that has been in the news, whose volatility is high, and for which a type skew existsBy doing so you will find that your risk will be reduced to virtually nothing. Now what if the stock you have chosen gets on a nice steady run and is at or goes above your appreciating collar strike price? If it is at the strike price, you can continue to hold and eventually let the calls and puts expire worthless, and then sell the stock to take your profits. If it is above the strike price, the calls you sold will carry away the stock and the put expires worthless; you garner the maximum profit potential of this position. 

To establish a collar, many strategists buy (or already own) the actual shares, buy an at-the-money LEAPS put, and sell an out-of-the-money LEAPS call. Doing so combines the covered call with a protective put. In theory, the call and put that are equidistant from the share price should carry the same premium. So, if you own a stock at $50 a share and want to protect the downside risk, you could buy a put. However, the put will cost money and the premium would be deducted from your account. Another option is to buy a 45 put and sell a 55 call. The sale of the call will reduce the cost of the purchase of the put.

Collar Mechanics

Let’s consider an example of a collar using XYZ. During the month of February, XYZ is trading for $50 a share and an investor has been holding the shares for some time. She doesn’t expect much movement in the stock, but believes that there is a 10 percent chance that the price will decline during the next four months and wants to hedge her exposure to all stocks—including XYZ. Therefore, with the stock trading for $50, she buys an August 45 put with six months left until expiration and sells an August 55 call. The options are both five points out-of-the-money (OTM). Since both the put and the call are five points OTM, they have similar premiums. In this case, each option trades for roughly $3. 

Luckily, with the stock trading for $50, the strategist is able to buy the put and sell the call at the same price. The cost of the trade is therefore zero because the shares are already held in the portfolio and the cost of the put is offset by the sale of the call. The risk to this trade is to the downside, but is limited to the strike price of the put. The maximum risk is equal to the initial stock price minus the strike price of the put plus the net debit (or minus the net credit). In this case, the maximum risk equals $500: [(50 – 45) + (3 – 3)] × 100 = $500. The maximum risk occurs if the stock price falls to or below the lower strike price (i.e., $45). Therefore, this strategy offers the trader a limited risk approach that makes money in either direction. 

FIGURE  Collar Spread Risk Graph

While there is limited risk associated with the collar, there is also limited reward. If the stock price moves higher, the position begins to make money. However, the maximum reward is capped by the strike price of the call. If the stock uiprice moves above the strike price of the call, the chances of assignment will increase. In other words, there is a greater probability that the stock will be called away at $55 a share. At that point, the maximum profit is realized. Namely, the higher strike price minus the stock price minus the debit (or plus the credit) is the maximum gain associated with the collar. In this case, it equals $500: (55 – 50 + 0) × 100 = $500. The maximum profit levels off at $55 a share, which is the point that assignment becomes likely. 

The breakeven is equal to the stock price plus the net debit (or minus the net credit). In this case, it is simply the price of the stock at the time the collar was established, or $50 a share. What are the risks associated with buying a put and selling a call on shares that we already own? First, the stock could move above $55, requiring us to sell it at a price lower than the current value; and second, the stock could still trade as low as $45 without seeing any profit from the put. However, this is also the case if we just held the stock as well. Much like catastrophe insurance, the idea behind a collar is that we don’t want to be stuck holding a stock as it falls into a tailspin. The collar is a form of disaster insurance.

Exiting the Position

While a collar can be tailored to make money when shares move higher, it is normally used for protection. It does not require a lot of attention. If the shares shoot higher, the stock will probably be called (due to assignment) when the time premium has fallen to a quarter of a point or less. Therefore, if the price of the stock has risen above the strike price of the short call and the strategist does not want to lose the shares, it is better to close the short call by buying it back. If not, the call will be assigned and the trader will make the profit equal to the difference between the exercise price and the original purchase price of the stock minus any debits (or plus any credits). 

The put, on the other hand, will protect the stock if it falls. If the stock drops sharply, the strategist will want to buy back the long call and then exercise the put. If the short call is not closed and the put is exercised, the strategist will be naked a short call. Although it will be deep OTM, it will still expose the trader to risk. Therefore, it is better to buy back the short call and close the entire position. If the stock stay in between the two strike prices, the trader can roll the position out using longer-term options or do nothing and let both options expire worthless. In addition, if you can monitor your collar trade a bit more closely, you can significantly enhance your returns when the stock in your appreciating collar rallies to your strike price. 

How can you do this? By rebracketing your collar. To rebracket the trader first would sell the put and buy back the call, then would recollar or create a new collar by buying a new at-the-money put and selling a new out-of-the-money call to create a new appreciating collar at the higher strike price. This is far better than just sitting and waiting for everything to expire after you already have capped your profits. Let’s look at a quick example for stock XYZ. We buy 100 shares of the stock at $50. We then buy the 50 put and sell the 55 call with a year still to go before expiration. Just a few months into the trade, the stock is trading at the $55 level. 

Now to lock in profits and pursue further appreciation in the stock, we would sell the 50 put and buy back the 55 call. We then would create another appreciating collar by buying the 55 put and selling the 60 call—locking in profits as well as being able to participate in further gains. This can be done over and over again throughout the year as the stock continues to climb. This technique gets around the capped profits limitation the standard appreciating collar possesses. If you have the time, the dynamic trading of collars might be something of interest. However, the traditional collar is still an excellent low- or no-risk strategy, which, if placed correctly, offers an excellent return. In fact, the return is enhanced even more if done in a margin account.

Collar Case Study

As we have seen, collars are combination stock and option strategies that have limited risk and limited reward. With this strategy, the strategist buys (or owns) the shares, sells out-of-the-money calls, and buys out-of-the-money puts. It is a covered call and a protective put (which involves the purchase of shares and the purchase of puts) wrapped into one. The idea is to have the downside protection similar to the put, but to offset the cost of that put with the sale of a call. As with the covered call, however, the sale of a call will limit the reward associated with owning the stock. If the stock price moves higher, the short call will probably be assigned and the strategist must sell the shares at the short strike price. This strategy is generally implemented when the trader is moderately bullish or neutral on a stock, but wants protection in case of a bearish move to the downside. 

Let’s consider a collar example using shares of American International Group (AIG), which are trading for $50.18 during the month of February 2003. In this example, the strategist buys 100 shares, buys an August 45 put for $3.30, and sells the August 55 call for $3. The sale of the call nearly offsets the purchase of the put and the debit is only $0.30, or $30 a contract. One hundred shares of stock cost $5,018 and the total trade results in a debit equal to the cost of the shares plus the net debit or $5,048: ($30 + $5,018). The maximum risk is limited also due to the protective put. No matter what, until the options expire, the stock can be sold for the strike price of the put, or $4,500 per 100 shares. 

The upside profit is also limited. If the stock price moves above $55, the call will probably be exercised. In that case, the stock is sold for $5,500 per 100 shares and the trader makes a profit. The breakevens are equal to the total cost of the trade per share. In this case, the breakeven occurs at 50.48. Notice that the trade generates profits if the stock moves higher, but the gains are limited by the strike price of the call. At $55 a share, profits level off. In between the breakeven and the upper strike price, the trade is profitable. On the other hand, if the stock falls below $50.48, the trade begins to lose money. The losses are capped by the lower strike price of the put, or $45 a share. Therefore, the collar carries some upside rewards, but also limited risks.  For that reason, many traders view the strategy as a form of low-cost disaster insurance. 

So, what happened to our AIG August 45 put/55 call collar? Well, three months later, in mid-May 2003, shares of AIG rose to $56 a share. At that point, the maximum gain had been recorded and, if the call had not been assigned (which it probably would not have due to the remaining time value), the position could be closed at a profit. The August 45 put is sold at a loss for the bid price of 60 cents a share. The August 55 call is bought back (buy to close) for the offering price of $3 and AIG is closed for $56. As a result, the call is a wash. The put results in a $270 loss and the stock is sold at $5.82 a share for a $582 profit. The total profit on the trade is $312: ($582 – $270). Excluding commissions, this collar generated a three-month 6.2 percent profit.

FIGURE  AIG Collar Spread 


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