We have discussed the definition of two options trading income strategies before: the short vertical spread and the iron condor.
In this article we would like to introduce you to another options strategy called the “calendar spread” which is also known as the “time spread”. Like the short vertical spread, when employing the calendar spread strategy, we are selling one option and hedging it with another option. In the case of the vertical spread, the option contract we are selling is more expensive than the option we are buying and that is the reason these are also called credit spreads.
Both options contracts expire on the same date as they are in the same option expiration series. With the calendar spread however we are going to sell one option contract and hedge it using another option at the same strike price, but in a later dated expiration cycle. In this case, because we are selling a nearer term option which is less expensive than the option we are buying (because the later term option at the same strike price will always have more time premium than the nearer term option contract at the same strike price) this would be done at a debit.
The calendar spread therefore has some similarities to the covered call strategy in which you own a stock and then sell the ATM call option for that stock “against” your long shares. In the case of a calendar spread strategy, we are using the longer dated option instead of the stock.
Let’s take a look at an example.
For the purpose of this illustration, IBM is trading at $200. To set up a calendar spread trade we would sell the 30 day option for $4.00 and then buy the 60-day option at the same strike price for $6.50. Thus our cost would be $2.50 or $250 total. This cost is our entire risk in the trade. The best case scenario for us, if we held the trade until the 30-day option expired, would be for IBM to stay right at $200.
If everything stayed the same, our 30-day option would be worthless and our 60-day option would have 30 days left to expiration and be worth approximately $4.00 according to standard options valuation models. So we would make a $1.50 profit on a $2.50 investment or 60% return. However, this is just an example and not a recommended trade plan. A typical option trade plan for income might include just taking a slice of the 60% potential return, perhaps exiting when you get to a 10% to 15% return.
In some cases, you can achieve this lower level of return in in a very short period of time—three to five market days. This lower objective is still a great return, of course, and if you do to choose to exit, you have ended your risk of being exposed to market volatility and potentially “giving back” the profits that you attained.
Prior to the introduction of weekly options, many income traders would initiate these types of options trades with 25–35 days prior to expiration of the front month. Now that weekly options have become popular, traders have developed many new ways of trading calendar spreads. One method would be to choose a long at-the-money option in the regular monthly expiration cycle options chain and sell the weekly option of the same strike that expires in the nearest week “against” that monthly option.
When that options trade is closed, we open a new trade in the same monthly option cycle but use the at-the-money option in the most current weekly options series, again at the same strike price as the monthly option that we are buying.
In the first example, the monthly option you bought might have 44 days to expire and the weekly option you sold might have nine days before it expires. In the next week, the monthly option would only have, say, 37 days and the new weekly option would have nine days again, as we are using a new cycle, which has nine days until expiration. So the prices you would be paying each time you “refreshed” the trade would tend to change as the long dated option comes down in price.
Another approach is to sell the front weekly option and then always buy the option one or two weeks longer dated than the front week. One advantage of this approach is that you become very familiar with the prices you are paying every week because the time until expiration in both options is always the same, whereas the variations in pricing are more pronounced when selling against a monthly long option.
Regardless of when in the expiration cycle you initiate calendar spread strategies, they present another opportunity to sell options for income while having a hedge to limit your losses. Calendar spreads offer a solid reward to risk, providing you with the potential ability to exit soon after trade inception, capturing an attractive portion of the possible reward.
Seth Freudberg and Michael Schwartz
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