Sorry!! The article you are trying to read is not available now.
Thank you very much;
you're only a step away from
downloading your reports.

The Pros and Cons of Wide Calendar Spreads

By

It's far more conservative when there's only one month separating expiration dates.

PrintPRINT

It seems to be a very attractive strategy: Buy an option that expires months in the future and then write calls against that option -- and collect a new premium every month. Many beginners think of this as similar to writing covered calls month after month.

But, it's not similar.

Minyan Harrison writes:

I'm just beginning to learn about options and overheard someone say, "Buy longer-term options and sell shorter-term options against it." Could you please explain this strategy and tell me why/when someone would use it?

Is this a conservative strategy?


This is a strategy favored by some traders. Personally, I don't use it and prefer alternatives. But please understand that each of us should use strategies that make us feel comfortable. There's nothing inherently wrong with this idea.

I don't consider this to be a conservative strategy.

Advantages

1. Time decay.
Longer-term options have a smaller theta (rate at which option loses value as one day passes). That means the position you describe is expected to make a small amount of money every day, all things being equal (which they seldom are).

2. Repeatability.
If the short-term option expires worthless, or is repurchased at a small price ($0.05 or $0.10 for example), then you still own your long-term option and can sell a new, short-term option against it. If you can repeat this trade several times (once per month), by the time your long-term option becomes the front-month option (and time to sell it) you'll have collected much more in time premium than you paid. And that makes the trade profitable. This is the ideal situation.

Disadvantages


Price movement.

1. When the stock moves much lower and you have a call spread (or higher and you own a put spread), the value of your long-term option declines by far more than you collected when selling the front-month call.

Thus, at the first expiration, you're already losing money. You must now sell another option against your long option. Which strike price do you sell? If you own a call with a 60 strike price and the stock is down to 52, do you sell the 55 call -- risking a move to the upside? Do you sell the 60 call, which will be a low-priced option and give you little chance to make much money -- unless the stock rallies back toward 60. This is a problem.

2. If the stock rallies to 70 instead of falling, the spread loses money because the price of the near-term option increases more rapidly than the price of your longer-term option. When you buy back your short-term call (when expiration arrives), you must decide which option to sell next. If you sell another call with a strike of 60, it will have little time premium and your chance for making money is going to depend on the stock price falling back toward 60.

If, instead, you choose to sell a call with a 70 strike price (in other words, an at-the-money call), you have a chance to make some decent money and recover the loss. But, if the stock price declines back to 60, you're worse off than when you started (because you paid far more to buy back the 60 call at the previous expiration than you collected for the recently written 70 call).

Bottom Line


You have good time decay with the position.

You have negative gamma, and any decent-size move is going to take away your profits.

Any-time spread has the same properties, but when you own a long-term option, the risk and reward are both magnified.

Calendar spreads with only one month separating the expiration dates is far more conservative -- and in that respect is very different from the spread you describe.

< Previous
  • 1
Next >
No positions in stocks mentioned.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.

 

 

 

 

 

PrintPRINT
 
Featured Videos

WHAT'S POPULAR IN THE VILLE