Basics of Calendar Spread Option Trading

12/15/2015 8:00 am EST

Focus: OPTIONS

For the benefit of all traders new to the world of options, James Brumley, of BigTrends.com, outlines calendar spreads, cites an example to illustrate his point, and highlights the biggest trading hurdle to overcome with this type of trade.

Calendar Spreads Explained

A calendar spread is simply a two-option trade that not only has a price movement element to it but also a time-based element. It's not entirely unlike a normal credit spread or debit spread, but the two options used to enter calendar spreads have differing expirations that effectively predict a particular price for the underlying stock or index at a certain point in time.

With calendar spreads—unlike typical debit and credit spreads—buy and sell puts or calls with the same strike price but a different expiration date. Though not always the case, most calendar spreads consist of a purchase of a put or call of the more distant expiration and a short/sell of the option with a nearer-term expiration. This usually means a net debit is necessary to enter the trade, meaning the trade must at least be closed out at a later date in order to make money from it. Ideally, the near-term expiry option will expire worthless, then the longer-term expiry gains in value on the underlying stock's or index's movement after the expiration of the near-term option.

In simpler terms, a calendar spread is effectively an ordinary option trade (buy low, sell high) that uses the sale of a similar option to offset the cost of a long/purchased option.

An example will best illustrate the concept of calendar spreads.

Let's assume 3M (MMM), currently priced at $155.00, looks poised to stagnate for a month or so, but after that—perhaps with some sort of catalyst like earnings—is apt to drop significantly. We could buy some 155 puts with an expiration four months out at a price of $7.65 (or $765 per contract). To offset some of that cost, we could sell some one-month puts with a strike of 155 at a price of $4.20 ($420 per contract). The total cost to enter this calendar spread would be $345...the difference in price between the two contracts. This also represents our maximum possible loss on the trade (and that assumes the shorted put option is exercised against us and we would need to exercise the four-month put option we owned).

After one month, if the near-term put expires worthless—if MMM remains below $155 through expiration—the long put is effectively owned at only a cost of $3.45 (or $345 per contract even though it's worth much more). Past that point, any downward movement from 3M shares adds to the overall profit profile of the trade. For instance, if MMM shares fall to $145 in the second or third month of the trade, the four-month 155 puts would reach a theoretical value of $10.70, or $1070 per contract. That would represent a 210% gain in the initial net cost. Avoiding the adverse exercise of the short-term put, however, is the key (and easier said than done).

Calendar spreads can work just as well in a bullish direction.

Let's say Yahoo (YHOO) is going through a corporate overhaul for the next several weeks and investors aren't sure what to make of it, but you believe down the road YHOO shares will respond favorably to the improvements and rise from their current price around $32.90. To use a calendar spread as a way to play this nuance, some out-of-the-money call options would be used. In this case, calls with a strike of $34 would work well, with a two-month expiration for the call being sold/shorted and a six month expiration for the longer-term call.

The shorted two-month 34 call would put $1.65 (or $165 per contract) in our pocket, while the purchased four-month 34 calls would cost us $3.20 (or $320 per contract) for a total net debit of $155 to enter the trade...our maximum possible loss, which is a loss only realized if the shorted call is exercised against us (which would only happen in the first two months of the trade). The maximum gain depends on the bullish move YHOO shares make after the near-tem call expires, if it expires without being exercised against us. If not, the four-month 34 calls are effectively owned at a net cost of $155 per contract even though they're worth more; the shorted call offset our cost. Even with a mere move to $36 from Yahoo shares by the end of the third month, the owned calls would be worth $3.40 or $340 per contract, representing a 119% gain on our initial cost of $155.

Again, avoiding having the near-term option exercised against you is the biggest trading hurdle with calendar spreads. In that most calendar spreads use options that are barely out-of-the-money to make them worthwhile, adverse exercises aren't uncommon.

As is the case with all complex option trades, traders looking to add this type of position to their repertoire should paper trade some first to get a feel for their nuances.

Calendar spreads are also called time spreads or horizontal spreads.

By James Brumley of BigTrends.com

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