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Calendar Spreads Tweak #5 (Like Writing Calls on Steroids)

Lots of people like the idea of writing calls. They buy stock and then sell someone else the right to repurchase their shares (usually at a higher price) by selling a call against their shares. If the stock does not go up by the time that the call expires, they keep the proceeds from the sale of the call. It is sort of like a recurring dividend.

If writing calls appeals to you, today’s discussion of an option strategy is right up your alley. This strategy is like writing calls on steroids.

Terry

Calendar Spreads Tweak #5 (Like Writing Calls on Steroids)

When you set up a calendar spread, you buy an option (usually a call) which has a longer life than the same-strike call that you sell to someone else. Your expected profit comes from the well-known fact that the longer-term call decays at a lower rate than the shorter-term call you sell to someone else. As long as the stock does not fluctuate a whole lot, you are guaranteed to make a gain as time unfolds.

If you are dealing with a stock you think is headed higher, you might write an out-of-the-money call (where the strike price is higher than the current price of the stock). If you are right and the stock moves up to that strike price or above, you might lose your stock through exercise of the call, but you would be selling it at that higher price and also keeping the proceeds of your call sale.

With options, you can approximate this risk profile by buying a calendar spread at a strike which is higher than the current price of the stock. If the stock moves up to that strike price as you wait out the time for the call you sold to expire, the value of the call you own will rise and you will also keep the proceeds from the call you sold. Your long call will not go up as much as your stock would have gone up (perhaps only 60% or 70% as much), but this is a small concern considering that you have to put up such a small amount of money to buy the call compared to buying 100 shares of stock. Most of the time, you can expect that your return on investment with the calendar spread to be considerably greater than the return you would enjoy from writing calls against shares of stock.

The tweak we are discussing today concerns what you do when the call you have sold expires. On that (expiration) day, if the call is out of the money (at a strike which is higher than the price of the stock), it will expire worthless and you get to keep the money you originally sold the call for, just like it would be if you owned the stock and wrote a call against it. You would then be in a position where you could sell another call with a further-out expiration date and collect money for it, or sell your original call and no longer own a calendar spread.

If the call on expiration day is in the money (i.e., at a strike price which is lower than the price of the stock), the owner of that call will likely exercise his option and ask for your stock. However, right up until the last few minutes of trading on expiration day, there is usually a small time premium remaining in the call he or she owns, and it would be more profitable for him or her to sell the call on the market rather than exercising it.

As the owner of an in-the-money calendar spread on expiration day, you could merely sell the spread (buying back the call you originally sold and selling the call you bought), making the trade as a sale of a calendar spread. As an alternative, you could buy back the expiring call and sell another call which has a longer lifetime. This would be selling a calendar spread as well, but the date of the call you sold would probably be not as far out in the distance as the call you originally bought. At the end of the day, you would still own that original call and you would be short a call which has some remaining life before it expires.

You can see that this tweak is much like what you could do if you were in the business of writing calls. Another similarity is that you might want to sell a new call which is at a higher (or lower) strike. You could do this with either the call-writing strategy or the calendar-spread (call-writing on steroids) strategy. If you replace an expiring call with a new short call at a different strike price, you would be selling what is called a diagonal spread and you would end up owning a diagonal spread as well. A diagonal spread is exactly the same as a calendar spread except that the strike price of the long call you own is different from the call that you sold to someone else.

One limitation of the options strategy is that if you want to sell a lower-strike call than you originally did, your broker would charge you with a maintenance requirement of $100 for every dollar difference between the strike of your long call and the strike of the call you sold. There is no interest charged on this amount (like a margin loan would involve), but that amount is set aside in your account and can’t be used to buy other shares or options. If you sold a call at a strike which was $2 lower than the strike price of your long call (creating a maintenance requirement of $200), and you were able to sell that call for $2.50 ($250), you would collect more cash than the amount of the maintenance requirement, so you would still end up with more cash than what you started with before selling the new call.

This all may seem a little complicated, but once you do it a few times, it will seem quite simple and easy. And from my experience, profitable most of the time as well, far more profitable than writing calls against stock you own.

Happy trading.

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