 Calendar Spread Option Strategy
When you are fairly neutral on the market and you want
to generate additional income from your investments,
there is an option strategy that is worth your
consideration. This strategy involves selling an
option with a nearby expiration, against the purchase
of an option (with the same strike price) which has an
expiration date that is further out.
A Calendar Spread is an option spread where the
strike prices are the same, but they have different expiration
dates. These spreads are also referred to as horizontal
spreads or time spreads.
Calendar spreads can provide a way to add value to your
portfolio through your purchase of a long term option
with a reduced cost basis, provided by a near term option
that you sold.
One very favorable point to a Calendar Spread is the
value of time decay. Although both options lose time
value as time passes, the option you sold loses value
much more quickly than the option you bought. Therefore,
if your prediction of a neutral market is correct, the
value of your Calendar Spread will increase as time
passes. A Calendar Spread takes advantage of time value
differentials during neutral markets.
When the near term option expires, you have several
alternatives. If you are still predicting a neutral
market, you can hold on to your long position, if there
is sufficient time left on it, and sell another short
term option against that long position. If you are dealing in calls and you fear that
the market may go down, you can close out your long
position and take the profits. If you are dealing in calls and you predict
a more bullish market, you could just hang on to your
long position and take a larger profit in the future.
In any of the cases, your cost basis on your long
position was reduced by the premium you collected
from the option you sold.
Another popular way the calendar spread is employed is in the simple rolling out of a position nearing expiry to a later month. If you have sold a covered call and it is about to expire, you may want to roll it out to a later month to collect more premium. This is also done to avoid having the stock called away from you.
It is also important to cover risks and caveats of this
strategy. Your loss is limited to the net premium you
paid (the money you paid for the option you purchased minus
the money you received for the near-term option you sold.
When we implement spreads of this nature, we try to
buy long term options that are undervalued. A good option
program like Option-Aid,
can help you verify that the long term option is undervalued.
For the short position, we look for options that are
overvalued, since we are selling that position. Option-Aid
can also help you verify that your short position is
overvalued. This strategy helps to maximize our profits.
There are many different ways to implement a Calendar
Spread, depending on your goals and your market outlook.
One popular implementation of the Calendar Spread is
try to generate income similar to a Covered Call strategy,
but involves buying LEAPS (Long Term Equity Anticipation
Securities) instead of the actual stock. So calls are
sold against the LEAPS instead of the actual stock. This
is done because the LEAPS can be purchased much more
cheaply than the actual stock, which can generate much
higher returns on invested capital. The risk with this
implementation is that the underlying stock goes down
in price instead of staying neutral, causing your LEAPS
to go down in value. If the underlying stock goes up in
price at expiration of the near term option (instead of
staying neutral), you could buy back the option you sold
and then sell another option, one or more months out.
When you implement this type of spread, you are hoping
that the near term option you sold expires worthless.
Then you can sell more options a little further out and
continue to collect more premium. This either decreases
the cost basis of the LEAPS you purchased, or produces
recurring income for you.
It is important to analyze your expectations for the
underlying asset and for the market before selecting your
strategy.
When you are analyzing potential option positions, it
helps to have a computer program like Option-Aid that
swiftly calculates volatility impacts, probabilities,
statistics, and other parameters of interest. These
programs can pay for themselves with the first trade that
they help you with.
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