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All About, or at Least an Introduction to Calendar Spreads

This week I would like start an ongoing discussion about one of my favorite option plays. It is called a calendar spread. It is also known as a time spread or a horizontal spread. But most people call it a calendar because that’s where you focus much of your attention while you hold this kind of a spread. On a specific date on the calendar, you discover whether you made or lost money since you first bought the calendar spread. In the next few blogs, I will discuss all sorts of variations and permutations you can make with calendar spreads, but today, we will focus on a bare bones explanation of the basic spread investment.

Terry

All About, or at Least an Introduction to Calendar Spreads

A calendar spread consists of the simultaneous purchase of one option (either a put or a call) and the sale of another option (either a put or call), with both the purchase and the sale at the same strike price, and the life span of the option you bought is greater than the option you sold. You can trade either puts or calls in this kind of spread, but not both in the same spread. You have to choose to use either puts or calls, but as we will see at a later time, it doesn’t make a whole lot of difference which choice you make.

Some things that we all know about options: 1) they all have a limited life span, and 2) if the underlying stock does not change in price, all options fall in value every day. This is called decay. In option parlance, it is called theta. Theta is the amount that the option will decay in value in a single day if the underlying stock remains flat.

The basic appeal of a calendar spread is that the decay (or theta) of the option that has been sold is greater than the decay (or theta) of the stock that was bought. Every day that the stock remains flat, the value of the spread should become slightly greater. For this reason, most buyers of calendar spreads are hoping that the stock does not move in either direction very much (but we will see that is not always the case with all calendar spreads).

Here is a typical calendar spread purchase on Nike (NKE) on August 24, 2016 when NKE was trading just about $60:

Buy to Open 5 NKE 20Jan17 60 calls (NKE170120C60)
Sell to Open 5 NKE 23Sep16 60 calls (NKE160923C60) for a debit of $2.20 (buying a calendar)

The options that are being bought will expire on January 21, 2017 (about 5 months from now) and the options being sold will expire on September 23, 2016, one month from now. You don’t really care what the prices are for the calls you bought or the calls you sold, just as long as the difference between the two prices is $2.20 ($220 per spread, plus a commission of about $2.50 per spread). That’s how much money you will have to come up with to buy the spread. This spread order will cost $1100 plus $12.50 in commissions, or $1112.50.

The all-important date of this spread is September 23, 2016. That is the day on which the short options (the ones you sold) will expire. If the stock is trading on that day at any price below $60, the calls that you sold will expire worthless, and you will be the owner of 5 NKE 60 calls which have about 4 months of remaining life. If NKE is trading at exactly $60 on that day, those 20Jan17 60 calls will be worth about $3.05 and you could sell them for about $1525, netting yourself a profit of about $400 after commissions. That works out to a 35% gain for a single month, not a bad return at all, especially if you can manage to do it every month for the entire year (but now, we’re dreaming). That is, alas, the maximum you could make on the original spread, and that would come only if the stock were trading at exactly $60 on the day when the short calls expired.

Here is the risk profile graph which shows the loss or gain on the original spread at various prices where the stock might be trading on September 23rd:

2016 NKE Risk Profile Graph September Expiration

2016 NKE Risk Profile Graph September Expiration

In the lower right-hand corner under P/L Day, the profit or loss on the spread is listed for each possible stock price between $58 and $62. Those numbers should be compared to the investment of just over $1100. The graph shows the maximum gain takes place if the stock ends up right about $60, and about half that gain would result if the stock has moved a dollar higher or lower from $60. If it rises or falls by $2, a loss would result, but this loss would be much lower than the potential gains if the stock fluctuated by less than $2. If the stock moves by a much greater amount than $2, even greater losses would occur.

One good thing about calendar spreads is that the value of the options you bought will always be greater than the ones you sold, so you can never lose the entire amount of money you invested when you bought the spread. If you just buy a call option with the hopes that the stock will rise, or buy a put option with hopes that the stock will fall, you risk losing 100% of your investment if you are wrong. Even worse, in most cases, you would lose the entire investment if the stock stays flat rather than moving in the direction you were hoping.

With calendar spreads, you should never lose everything that you invested and you don’t have to be exactly right about the direction the stock needs to move. There is a range of possible prices where your spread will be profitable, and if you enter your proposed spread in a software program like the (free) Analyze Tab at thinkorswim, you can tell in advance what the break-even range will be for your investment.

There are ways that you can expand the break-even range so that a greater stock price fluctuation could be tolerated, and that will be the subject of our next blog.

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