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When traders first get involved with the stock market, it usually is with mutual funds; When they want to take more control of their portfolios, they might start trading individual stocks. However, stock traders quickly find that the stock market will often move sideways and there isn’t a way to profit when trading stocks. Thus, the next logical step is a move to options. This is because there are various option strategies that profit when a stock doesn’t do anything. One of these strategies is called a calendar spread and this is the strategy I’d like to discuss for the next few months.

A calendar strategy is made up of two options, both puts or both calls, that have the same strike, but different expiration months. Since the expiry date is different, the term calendar spread was used for this strategy. The idea behind a calendar spread is that the stock is going to make little net movement, so we sell a near term option and buy a long term option. The key to success in a calendar spread is time decay.

Time decay is the value lost in an option due to the passage of time. If we have an option that is out-of-the-money [OTM] at expiration, it will be worth nothing. If we sell an OTM option and it doesn’t move in-the-money [ITM] by expiration, we keep the entire premium. However, if we were to only sell an option, we would have unlimited risk as the option moved against us. For example, if sell an Apr. 30 call with the underlying at 30, we might received a credit of say two dollars. If the stock stays 30 or moves lower by expiration, the two dollar premium is ours to keep. However, what if the stock moves to 50? At this point, the personal holding the other side of the trade will want to buy the stock from us at 30, so we have to buy it at 50 and we lose the 20 dollars per share difference.

A calendar spread alleviates this risk by adding a long term option. This way, if the stock rises when using a call calendar spread, we are only at risk the net debit paid to get into the trade. The same holds true for a put calendar, except that our risk is to the downside for the sold put. The obvious question here is how do we profit if we have sold a 30 call and bought a 30 call? Let’s answer this question so that we can see the benefits of a calendar spread.

The key to the success of a calendar spread is that we are selling a front month option and buying an option that is say three or more months out. Time decay accelerates the last 30-days of an options life. Therefore, even if the stock sits still, the front-month option will lose more value than the back month option. Let’s use an example to further illustrate this point.

Below we show how a theoretical trade would fare given 20 percent implied volatility.

Sell Apr. 30 call @ 0.55
Buy Jul. 30 call @ 1.42
Net Debit = 0.87

At April expiration, if the stock were still at 30 and IV is still at 20 percent, the trade would look like the following:

Apr. 30 call @ 0.00
Jul. 30 call @ 1.29
Net Credit (1.29) less debit (0.87) = 0.42 per share

In this example, $0.87 was the cost and the gain was $0.42, which is nearly a 50 percent gain. Not bad for a stock that did nothing. The risk is that the stock will rise or fall sharply before expiration. However, the max risk remains the debit paid to enter the trade. By using an options calculator, we can test the possible gains and losses for a potential trade.

Another advantage to using a calendar spread is that we can sell another option the next month if the stock is still near our strike price. This way we continue to bring in profits, which eventually might pay for the long option, leaving any value in the long option as profit. Some traders will use a calendar spread to pay down the cost of a LEAPS, expecting consolidation in the near-term, but gains in the stock longer term.

Next week, we will choose a stock to enter a calendar spread on so that we can see how this strategy works in the real world. In the meantime, if you have any questions or comments, feel free to voice them on my discussion board.

To read previous installments of Real-World Trading, please click here.

Jody Osborne
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
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