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Calendar Spreads Tweak #2

This week we will continue our discussion of a popular option spread – the calendar spread which is also called a time spread or horizontal spread. We will compare the expected costs and potential returns if you select different time periods for the long and short sides of the calendar spread.

Terry

Calendar Spreads Tweak #2

First, let’s look at a typical calendar spread on Facebook (FB). Today, the stock is trading just over $130, and you might buy an at-the-money calendar spread by placing this order:

Buy To Open 1 FB 16Dec16 130 call (FB161216C130)
Sell To Open 1 FB 14Oct16 130 call (FB161014C130) for a debit of $3.75 (buying a calendar)

This spread would cost about $3.75 ($375) to buy, plus $2.50 in commissions at the rate Terry’s Tips’ subscribers pay at thinkorswim, for a total of $377.50.

When the 14Oct16 call expires on October 14, 37 days from now, this is what the risk profile graph indicates the profit or loss would be at the various possible stock prices that might exist at that time:

 

Face Book Risk Profile #1 September 2016

Face Book Risk Profile #1 September 2016

Note that the break-even range extends from about $3.50 in both directions. The loss or gain when the short call expires on October 14th is indicated in the column on the lower right titled “P/L Day.” The maximum gain is precisely at the $130 price, and it is about $150 which would result in almost a 40% gain for the month.

When this calendar spread expires on October 14th, there will be 3 months of remaining life to the 16Dec16 call that you would hold. This call will always have some value that is greater than the 16Dec16 call that is expiring on that day, no matter where FB is trading at that time. This means you can’t lose the entire $377.50 that you have invested. The closer to $130 FB is at that time, the more valuable your 16Dec16 call will be in terms of remaining time premium.

Let’s check out what the situation might be if we went further out in time and bought a calendar spread that had both sides two months later. The difference between the long and short sides of the spread will remain at three months but you will have to wait three months rather than just one month to have the spread expire and you take your losses or gains. This would be the spread that you would buy:

Buy To Open 1 FB 17Mar17 130 call (FB170317C130)
Sell To Open 1 FB 16Dec16 130 call (FB161014C130) for a debit of $3.25 (buying a calendar)

This spread would cost about $3.25 ($325) to buy, plus $2.50 in commissions at the rate Terry’s Tips’ subscribers pay at thinkorswim, for a total of $327.50. (Buy the way, the regular commission on this spread at thinkorswim would be $7.80, and for this reason, many people choose to become Terry’s Tips subscribers because this low rate will extend to all the trades they make in their account, regardless of whether or not they are following one of our portfolios. The commission savings could be greater than the low monthly cost of being a subscriber).

When this spread expires on December 16th, this is what the risk profile graph would look like:

Face Book Risk Profile #2 September 2016

Face Book Risk Profile #2 September 2016

Note that the break-even range has more than doubled so that the stock can fluctuate about $8 in either direction before the spread starts losing money. Of course, you have to wait three months for December 16th to come around, and this gives the stock lots of time to make a big move in either direction. Again, the further it moves away from $130, the less money it makes. If the stock remains unchanged, and ends up at about $130 on that day in December, the expected gain is over $350, or more than 100% of the original cost of the calendar spread.

Presumably, you are trading calendars on a stock you believe is headed higher. If you believe that FB is likely to be trading about $5 higher three months from now, you might buy the same calendar at the 135 strike instead of the 130 strike. It would cost a little less, about $315, and this is what the risk profile graph looks like for December 16th:

Face Book Risk Profile #3 September 2016

Face Book Risk Profile #3 September 2016

If the stock stays flat, the spread will make about $150, or about 45% on your investment, but if it goes up $5 and ends up near $135, you could gain over $370, or well over 100% on your investment. The break-even range extends less than $5 to the downside and about $16 on the upside, so you will be rooting for FB to move higher over the three months.

The key point to selecting the strike price of calendar spreads is to make your best guess as to where the stock might be at the future date when the calls you have sold expire. If you are right, you could enjoy some extraordinary gains.

As usual, there are no easy ways to make sure gains in this world. You inevitably must make some sort of guess as to what the underlying stock will do. The neat thing about calendar spreads is that you don’t have to be precisely right. There is a fairly large range of possible stock prices withing which gains could come your way. The further out in time you go to select dates for a calendar spread, the greater the break-even range will be, and the maximum gain will always come if the stock ends up precisely at the strike price you select when you buy the spread.

As with all investments, you should only plunk down money that you can truly afford to lose. Option spreads can make excellent gains, but large movements in the stock price in either direction could cause losses with calendar spreads (unless you anticipated that direction and selected the right strike price at the outset).

Happy trading.

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