9 Weeks to Better Options Trading: The Power of Calendar Spreads
Veteran options trader Steve Smith breaks down this strategy.
In the past two weeks, we've gone over rookie mistakes to avoid as well as the basics of options pricing (see: 5 Rookie Mistakes to Avoid Like the Plague and An Options Pricing Primer). Now it's time to move on to trading methodologies, the first of which is calendar spreads.
Calendar spreads, which are also known as time spreads, are one of the most useful options strategies out there because they allow us to make directionally-biased trades at a lower cost basis than with outright purchases of puts or calls. Calendar spreads offer the hope-springs-eternal element that keeps us all coming back to trading options.
Supposedly, time is on our side, and the never-ending cycle of options expirations means we can keep rolling our positions forward, always chasing that perfect confluence of time and price. But that ain't the way I play it. I don't want to be beholden to time, or be led down some primrose path. If time doesn't make me money, I walk away and don't look back. But enough with the fanciful and back to the prosaic.
What exactly is a calendar spread? A calendar spread is constructed through two simultaneous trades: 1) the purchase of an option, and 2) the sale of another option with the same strike price, but an earlier expiration. This combination creates a fairly neutral position that benefits from the accelerated time decay of the front-month option sold short. As we discussed last week, as an option gets closer to expiration, the rate at which time value decays accelerates. In other words, the near-term option loses time value much more quickly than the longer-dated ones. The maximum profit would be achieved if the price of the underlying is at the strike price of the front month sold short at expiration, rendering it worthless.
As an example, we'll look at Wal-Mart (WMT), which has traded sideways since the Paleolithic age, meaning one could reasonably expect it to remain between $55 and $65 for the foreseeable future. With the stock trading at $61.10 we could: 1) sell the April $62.50 calls at $0.30 a contract, and 2) buy the June $62.50 calls at $0.80 a contract. This gives us a $0.50 net debit for the calendar spread. That $0.50 cost is the maximum risk. A perfect scenario would be that Wal-Mart creeps higher over the next month, but is below $62.50 at the April expiration, rendering the short April call worthless. All else being equal, with a $62.50 share price and two months remaining until the July expiration, the July calls should have a value of around $1.70. The position would have a $1.20, or 140%, profit on the initial $0.50 outlay.
But don't think calendar spreads are necessarily easy money. There is a significant challenge in getting the timing right. If the underlying stock price moves too quickly and deeply into the money, the value of the spread will decline as both options move toward intrinsic value. And few stocks trade in a straight line like Wal-Mart. In fact, most will try your patience of holding fast to an "unchanged" price over many months.
In addition, there are outlier risks in the form of unforeseen news events like a merger/takeover, or a legal or FDA ruling, that spikes shares higher. In such cases, a "terminal value" (call it takeout price or the lifting of unknown outcomes) will cause the value of the shares to spike. But with the unknown event now clarified, the long-term option's implied volatility will plummet, and it will lose its time premium, even though there could be many weeks or months for the deal or decision to be handed down. This is because much of the uncertainty regarding future price action would be removed. And since calendar spreads benefit from the longer-term option retaining time value more effectively than the near-term dated one, they would suffer if the time premium was eliminated all at once.
So, there are two important takeways here:
1. A long calendar spread is a long volatility position. This means it benefits from an increase in implied volatility.
2. A news event, such as the confirmation or failure of a merger, will diminish the range of possible outcomes, causing a decline in implied volatility, especially at the later-dated options.
The Diagonal Calendar Spread
The diagonal calendar spread is one of the most useful calendar-spread variations.
To construct a diagonal calendar spread -- and we'll just focus on a long spread here – we combine the following: 1) the purchase of a later-dated option and 2) the sale of a shorter-dated option with a strike that's further out-of-the-money. This gives the position a stronger directional bias, or a higher delta than a straight calendar spread.
Here's an example of a diagonal calendar spread in Google (GOOG), with shares trading around $628:
- Buy the June $625 calls at $31
- Sell the May $640 calls at $20
The best scenario is that Google is at $640 at the May expiration, meaning those May calls expire worthless, and we are now outright long the June $625, now worth $15 intrinsic ($640 - $625 = $15), at an $11 cost basis. That is a 36% profit.
If you had just bought the June $625 calls outright at $31, and shares of Google stood at, say, $630 on the May expiration, the June calls would have a value of about $23 a contract – a loss of about $8, or 25%, mostly due to time decay. (Note: The $23 value was calculated using a standard options calculator.) Meanwhile, with the calendar spread, the May $640 calls would have expired worthless, netting you $11 of premium, for a $12 profit during the two month holding period.
If you're confused by the math: The May $640 call expired worthless, while the June $625 call is worth $23. The initial net cost was $11. With the June call now worth $23, we can subtract the initial $11 cost for a $12 profit.
Nearly all that profit was the result of the shorter duration, further out-of-the-money call experiencing a greater rate of time decay. In this example, with only a moderate increase in the stock price, and all else being equal, one can see how harnessing time decay can provide a powerful tailwind to profitability. On the other hand, by just buying the calls outright, one could have actually lost money -- even though the stock went up!
The possibilities for profits and adjustments on calendar spreads can be practically endless. My approach to calendar spreads in the OptionSmith portfolio is to keep them dynamic. I don't have static price targets. Rather, I respond to the market to best exploit the acceleration of time decay of the front-month option to provides an edge in the form of a lower effective cost basis.
One of my typical adjustments to calendar spreads is to roll the option sold short up to a higher strike to extend the position in terms of time and amount of premium taken in. I do this frequently with names that offer weekly options such as the Spyder Trust (SPY), Amazon (AMZN), Google, or even iShares Barclay's Bond (TLT). These never-ending mini-expiration cycles allow me to capture the steep part of the decay curve on a more frequent basis. However, they also require more attention and willingness to take quick profits and losses when things don't play out as planned.
One thing I should I add at this point is that options education is not linear, but rather circular. While you need to start at a certain point, such as understanding option pricing models, they really don't mean much until you start examining and applying certain strategies. So be patient. It may be a dizzying journey, but it's also a rewarding one.
For complete access to Steve Smith's trades in real-time, check out the OptionSmith portfolio, which returned 28% in 2011. Click here for more details.
Here is a complete schedule for "9 Weeks to Better Options Trading":
Week 1: 5 Rookie Mistakes Options Traders Make
Week 2: Option Pricing Basics: Understanding Implied Volatility and Time Decay
Week 3: Trading Strategy: The Power of Calendar Spreads
Week 4: Trading Strategy: Butterfly Spreads
Week 5: Trading Strategy: Condors; Iron and Others
Week 6: Trading Strategy: Risk/Reversals
Week 7: Trading Strategy: Back Spreads
Week 8: Managing Risk
Week 9: Special Situations: Earnings Reports, Takeovers, and Extreme Market Moves
For more from Steve Smith, take a FREE 14-day trial to OptionSmith and get his specific options trades emailed to you along with exclusive access to his full portfolio. Learn more.
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