Calendar Spread

 

Description

 

Calendar spreads are known as horizontal spreads, and the Calendar Call is a variation of a Covered Call, where you substitute the long stock with a long-term long call option instead. This has the effect of radically reducing the investment, thereby increasing the initial yield. However, this initial yield is not necessarily reflective of the maximum yield at the expiration of the short-term short call. The maximum yield will depend on both the stock price and the residual value of the long unexpired call.

 

The problem with a Calendar Call is in the very essence of the shape of the risk profile (see the following). What we would like to do is create something similar to a Covered Call, but with a better yield and without the expense. The Calendar Call certainly requires less investment; however, the shape is different. If the stock rises too far too soon, then the Calendar Call can become loss-making. So even though you got the direction of the trade right, you could still lose money!

 

This happens because the long call, being near the money, only moves at around half the speed as the underlying stock as the stock price rises. This means that in the event of exercise, if the stock has risen by, say, $10.00 from $30.00, and your option has only risen by $5.00, you may be exercised on the short call; therefore you buy the stock at $40.00 and sell it at $30.00 (if that was the strike), yet your long call has only risen by $5.00, giving you a $5.00 loss. If you only received $2.00 for the short call, you are looking at a $3.00 loss on the trade.

 

Both options share the same strike, so if the stock rises above the strike, your short call will be exercised. You will then have to sell the long call (hopefully for a profit), use the proceeds to buy the stock at the market price, and then sell it back at the strike price. Therefore, the best thing that can happen is that the stock is at the strike price at the first expiration. This will enable you to write another call for the following month if you like.

 

Market Opinion

 

Neutral to bullish.

 

P/L

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

When To Use

 

Use this strategy when the environment is neutral to bearish and you want to generate income on your long term position by selling calls and receiving the premium.

 

Example

 

XXXX is trading at $65 on May 12, 2011. Normally, it has 30% volatility.

Buy January 2013 65 strike calls at $12.50.

Sell June 2011 65 strike calls at $2.70.

 

Benefit

 

The benefit of this trade is the ability to generate some income on your long term position by selling calls to receive the premium.

 

Risk vs. Reward

 

The risk is limited to the net debit of the calls you bought minus the calls you sold. The reward is limited to the remaining call value when the stock is at strike at expiration, minus the net debit.

 

Net Upside

 

Long call value when short call expires (when stock is at strike price) net debit.

 

Net Downside

 

The net debit paid.

 

Break Even Point

 

Depends on the value of the long call when the short call expires.

 

Effect Of Time Decay

 

Negative, in that it decays the value of the long call. However, it helps income by eroding the short call faster.

 

Alternatives Before Expiration

 

Let the short call expire worthless and keep the entire premium if the stock stays under the strike, but above the higher stop loss. If you wish, you can write another call for the following month.

 

Sell the long or reverse the position if the stock falls under the lower stop loss.

 

Alternatives After Expiration

 

If you are exercised, sell the long call, buy the stock at market price, deliver it at the strike price, and profit from the short option premium you received as well as the long option premium. Do not exercise the long option so as not to lose its time value.