Long Calendar Spread - How to Video

optionsguy posted on 09/13/12 at 11:39 AM

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Posted by optionsguy on 09/13/12 at 11:39 AM

Hello, my name is Brian Overby. I am the Senior Options Analyst at TradeKing, and author of The Options Playbook. We’re going to focus on a play that’s inside The Options Playbook today called the Long Calendar Spread. Now, the Long Calendar Spread is a tricky option strategy in that we’re trying to take advantage of the fact that options decay over time. Not only are we going to take advantage of that, we’re actually thinking about the fact that shorter term options decay at a faster rate than longer term, options. So let’s look at the definition of a Long Calendar.

A Long Calendar Spread is the simultaneous sale of a near term option and the purchase of a far term option, otherwise known as a back month option, of the same strike price and the same type, either a put or a call. Now, when we do this we’re buying the longer term option so we’re paying for this calendar spread. Our two examples here, we’re looking at on the call side we might sell a July 50 call and buy an August 50 call, or we can do it with puts and we could sell a July 50 put and buy an August 50 put. Bottom line with long calendars, you’re selling the near term option and you’re buying the further out in time option.

Let’s look at an example using the concept of time decay to explain this. Once again we have a fictitious stock, XYZ, it’s trading at 100. We’re going to make it a very simple example, in that we’re only going to talk about using a 30-day option and a 60-day option. We will be buying the 60-day option, we’ll call that the August option contract, at the 100 strike, the option contract that’s right at the money, and we’re going to sell a 30-day option, the July option, 100 strike call. The longer term option costs more, it’s $3.50; the shorter term option is $2.50. The entire cost of the trade is a $1 debit to the account. The commission to do the trade is $6.25. So now remember, this is a multiple leg trade so you do have increased commissions, and you want to think about tax treatments that are involved, but the max risk of this trade is that net debit paid, that $1.

Now if we look at the graph we actually show on the horizontal line the two different expirations, we have the July expiration, we have the August expiration. On the vertical axis we have the actual price of the option contracts. You can see over time, if we look at the curvature of the time premium in the July option versus the time premium in the August option, you see how much more rapid the decay is in the July month versus the August month. This is the reason why people want to do Long Calendar Spreads. They’re trying to take advantage of that time decay.

Now, the big question is though, what’s my profit potential?  What’s the maximum profit that I could possibly make on this trade?  And if we look at the next slide here we now see a dotted line that goes from the July expiration straight up and touches the August line, or curvature, and then goes over and actually shows you about what the premium would be.

This is fairly important to note that, well, if we put this entire trade on for $1 and we’re dead right on our forecast and the stock doesn’t move at all, it stays right at 100, in other words you’re a perfect stock picker, bottom line is at the expiration of the July option contract this kind of indicates that, all things being equal, that option should be trading for about 250, which is kind of interesting to note, guess what, the July contract started at when we first did the trade, 250. Well, that makes sense because we have perfect timed options in our example. We have a 30-day option; we have a 60-day option. After 30 days goes away, the 60-day option, what should it be trading for?  Well, what the 30-day option was trading for to start with, and in this instance the graph shows that via the curvature, and we know that over all, as long as everything remains equal, it should be trading for about that.

The hardest thing about long calendars is trying to understand what is the maximum that you can make on the trade?  And then you have to realize that’s very hard to do. That means none of the variables in the marketplace have changed and the stock price is right at the strike price.

Let’s go on out and look at, well, where are our break-evens on this strategy?  That’s even a harder question to address, and for that let’s look at another slide and in this slide we’re going to actually have just a distribution of option prices over different strikes.

We have a 30-day option with the stock right at 100. That 100 strike, in this instance, is going to be $2.50. Now let’s go on out and look at different strikes in and out of the money. Since this is a call option the 102.50 strike would be considered out of the money, it would be out of the money by $2.50 with the stock right at 100. We see that option contract is trading for $1.35. If we go a little bit in the money we see the 97.50 strike is trading for a little bit more, because it has intrinsic value, and that’s trading for $3.85. Now, 5 points in and 5 points out at the 105 mark and at the 95 mark, we see at 105 the option is trading for 70 cents, and at 95 it’s trading for $5.70.

Now let’s take the slide to the next level and actually look at the overall time premium that’s inside the slide. If we remove that intrinsic on the in the money calls we see that, all things being equal in a utopian marketplace, if an option is $2.50 in the money it should have the same time premium as an option that’s $2.50 out of the money. So in this instance we see the 97.50 strike trading with $1.35 of time premium, which guess what, happens to be what the out of the money option, the 102.50 strike is trading for.

This is very important to understand when it comes to trading Long Calendar Spreads. Why is that, because you can only capture time premium. If there is no time premium in that option contract there is going to be no benefit to doing this trade. So if you understand this distribution of time premium you can kind of see, if the stock goes up $2.50 here, well, we’re still going to be profitable on that trade. We paid $1 for it, we can capture $1.35 in time premium hence we would be up 35 cents on the trade. And if it went down $2.50 we still have $1.35 of time premium left in the option contracts, so also we’d be up 35 cents on the trade.

But now, if it goes up 5 points or down 5 points, guess what, all the time premium that is left is 70 cents, in our example.  So in that instance, we would be down on this trade. We basically paid $1 for it, and we would only be able to capture 70 cents. The further it goes out of the money, and the further the underlying goes in the money, time premium is going to erode and eventually go away, hence when you’re doing these trades you need the stock to stay within a certain range in order to be profitable on that trade.

Here’s one thing, here at TradeKing you’re kind of lucky if you like to do long calendars because we have a profit and loss calculator that will graph this for you and show the potential range, all things being equal. The Long Calendar Spread is definitely a hard trade to understand, especially if it’s your first time doing it. So I wish you the best of luck on it.

If you’d like to learn more about these topics, please check out our Learning Center on tradeking.com. Also you can find answers to your questions inside our Trader Network, where many traders like to share tips and talk about where the marketplace is going to next. I’ve also authored The Options Playbook, which is available for purchase on Amazon.com, and you can actually view it online for free at optionsplaybook.com. If you’d like to hear more about my thoughts and tips, check out my blog on our Trader Network, just look for The Options Guy.

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