Calendar Spreads

A calendar spread (time spread) options strategy consists of the sale of one call and the simultaneous purchase of a call of the same underlying security with the same strike price but with a strike price further out. An example would be the sale of an XYZ November 95 call for 3-1/2, and the simultaneous purchase of the XYZ January 95 call for 6. Assume XYZ common stock is presently trading at 95. The object is to have XYZ stock close below 95 at the close of November expiration.

Should XYZ close below 95 at November expiration, the November 95 call would expire worthless for a 3-1/2 point profit. The XYZ January 95 call would probably be worth about 3-1/2. The original position cost the investor the difference between the call sold and the call purchased (plus commission). Thus, the original cost (debit) for the investor was 2-1/2. At November expiration, the investor could close the calendar spread out. The result would be the 3-1/2 points received from the long call. Subtract from this the original debit of 2-1/2, and the result is a profit of 1 point. The underlying security only has to be at about the strike price of the sold call. Profit can be made in a narrow range. However, if the underlying security is far above or below the sold strike price, a loss may occur.

The options strategy just described is a neutral outlook strategy. That is, the investor doesn’t think that the underlying security is going to move much in either direction prior to the November expiration. However, the investor can also create an aggressive and bullish calendar spread with call. In this case, with XYZ trading at about 96, he might sell the XYZ November 100 call for 1-3/4, and buy the XYZ January 100 call for 3-3/4. First, the investor wants the November 100 call to expire worthless; and second, he wants the price of the underlying security to rise in price after November expiration. If this happens, he will own the January 100 call at a price of 2. This is the amount of the original debit. At this point, the break even point would be 102. It’s not unreasonable to expect that a volatile stock like XYZ could move 6 points in two months.

Follow up action for the neutral calendar spread is to close the spread if the sold call is trading near parity. The investor wants to avoid an early exercise with this options strategy since this would involve additional stock commission costs.

Should the underlying security rise quickly after the calendar spread is established the investor has two choices. First, he can close out the calendar spread early for a small loss. Or second, he can ride out the spread until November expiration hoping for the stock to decline. Should the underlying security decline in price sharply after the spread is initiated, he could sell the long call in an effort to recover a little something and keep the short call on. This is a dangerous options strategy. The trader is left with a naked short call. If the stock remains depressed, the call expires worthless and the trader will profit. However, if the underlying security rises in price drastically prior to November expiration, the losses are potentially unlimited. I don’t ever recommend leaving an uncovered (naked) option. The risk is just too great in any options strategy.

Follow up action for the trader who initiated the bullish calendar spread is to close the spread if the underlying security moves up in price too high, and the spread is profitable. A small loss is the preferred options strategy. It is not recommended to close the short leg and ride out the long leg. If the underlying security declines in price, a larger loss may occur. It is also not recommended to leg out both sides of the bullish calendar spread. The concept behind this type of spread is that the more frequent small losses will be overwhelmed by the less frequent large gains.

There is one other possible options strategy one can use when initiating a calendar spread. That is to buy a longer term option and sell the near term option. An example would be to sell the XYZ November 95 call for 3-1/2, and buy the XYZ April 95 call for 8-1/2. At November expiration, assuming the price of XYZ is below 95, the November call would expire worthless, and the April call would be worth about 6. The investor could then sell an XYZ January 95 call for about 3-1/2. At January expiration, assuming the price of XYZ was still below 95, the investor would have brought in 7 points against the 8-1/2 points the investor originally paid for the April 95 call. Thus, at January expiration, he would be holding an April 95 call worth about 3-1/2 points for an overall cost of 1-1/2. He could then sell the April call and realize his 2 points profit, or hold the call if he expected the price of XYZ to rise by April. This is an options strategy which is not used as much as it could be by traders using calendar spreads.