Calendar Spreads Offer Three Ways to Win in this Current Environment
This spread is a good strategy in low volatility environments because it will likely gain value if volatility was to rise. Say we’re heading into an earnings event, the stock might not be going anywhere leading up to the event, but it’s highly likely the premiums in options will rise in value as investors position for or hedge against a possible big move following the earnings release. In this spread where two different options are held long and short, the back-month call option that we’re long will increase in value more than the nearer month option that we’re short, causing the total value of this spread to rise. That’s the first way we can win.
The second way we win is if the underlying stock trades up to our strike prices. Generally, I like to choose out-of-the-money strikes that correspond with a price level that we either see as showing the potential for a bit of resistance which might slow or halt the stock’s advance, or a price target level that makes sense based on technical analysis the team at All Star Charts has performed. If the stock trades to that level, we can close the spread right there for a gain. While we likely may have lost money on the short option leg of the spread, the long option will much more than make up for it. This isn’t necessarily going to be a big win (though sometimes it will!), but it will be a win nonetheless. We always close the spread here because if the underlying were to continue to ramp higher, you’ll find the short option and the long option will begin to converge in value, leaving the net value of the spread close to zero. No bueno. Therefore, when our strike levels are hit — we’re out. No debate.
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Profit profile of a hypothetical Calendar Spread. You can clearly see why it doesn't pay to hold on if the stock continue to trade higher from our strike price (represented at 75 in this example).[/caption]
The third way we can possibly win holds the most upside. Let's say we're watching ticker XYZ currently trade around $42 per share and we've identified $45 as a possible resistance area -- so 45 is the strike we'll be targeting with a calendar spread. Let's pretend it's early October. In this case we'd choose the November 45 calls (approx 45-50 days to expiration) to short, and we'd choose the December 45 calls to purchase. Lets say the short call was sold for 50 cents and the long call was purchased for $1.50, therefore this spread cost us $1.00 net (cheaper than buying the December 45 calls outright). This $1.00 represents the most we can lose. XYZ could trade to zero or infinity and our net loss would still only be $1.00.
Now lets work though the most profitable scenario:
For the next 6 weeks leading up to November expiration, XYZ trades in a range between 40 and 44.50, but never quite reaching our 45 strike. In this case, the short November calls would expire away worthless (or maybe you were aggressive and covered the short calls for a very cheap price -- say 5 cents), this now leaves you long the December 45 free and clear at a net cost of $1.00 (the original purchase price for the entire spread). Then, the good stuff happens...
Now the move we were positioning for begins to materialize. XYZ trades up and through our 45 strike. But since we're no longer short the 45 November calls, we don't need to close the position here. Now we hold for theoretically unlimited gains. XYZ then trades up to $50 and we're sitting on December 45 call options that now are valued at least $5.00 because they are $5 in-the-money --- this represents a 400% gain on our original $1.00 investment. From here, we simply manage the trade the way we'd manage any long call position -- treat any way in-the-money long options as if you are long the equivalent amount of stock and choose your exit based on price action.
I hope this gives you a nice peak into the way I like to trade Calendar spreads. In this market environment, I expect to continue executing these types of trades because I love the multiple ways to win, the ability to get long volatility for a potential mean reversion (especially if earnings are in the not-to-distant horizon), and the ability to reduce my net cost and therefore my risk.
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