Back to the grind, folks...so far in this series we’ve defined calendar spreads and talked through a few tips for finding a good underlying. Today’s post wraps up the tips, plus explores adding a little directional spin to calendars.
(I chose today’s image to emphasize the directional: if you’re feeling just slightly “thumbs up” or “thumbs down” on a stock, there are ways you can express that via calendars. This logo for “Thums Up” – no “b” – is actually one of the most popular sodas in India, similar to Coke.)
Consider OTM versus ATM options – they’re cheaper. You may be starting to notice how you can tweak calendars to suit your predictions, and one of those ways is in choosing OTM versus ATM options. OTM premiums tend to be cheaper than ATM, which can help you put on a calendar spread at a lower cost.
Feeling slightly bullish or bearish? Put a directional spin on your calendar. If you’re slightly bullish on the underlying, you can construct the time spread with calls and choose a slightly higher strike to reflect that. Let’s walk through an example, based on the original example from the first post of this series.
Stock XYZ @ 110
Buy 1 60-day (Feb) 115 call @ -2.50
Sell 1 30-day (Jan) 115 call @ +0.95
Net debit -1.55
Two concepts at play here: we put this on slightly OTM, which reduced our net debit cost slightly. (If we’d chosen 110 ATM calls, the sold leg would bring in 3.00, while the bought leg would cost 4.80, for a net debit of -1.80.) And in choosing calls with a slightly higher strike, our best-case scenario happens if the stock moved up slightly to finish at 115. The sold call would expire worthless, so we could keep the 0.95 premium. Meanwhile, the back option would become an ATM 30-day option - capturing the maximum possible time value for this trade, at a more affordable cost to put on the trade.
On the flipside, you can reflect a slightly bearish sentiment by constructing your calendar spread with lower-strike puts. There’s an added advantage to puts here, too: puts are typically cheaper because of synthetic relationships and carry costs. Explaining the why’s behind that could take up a whole other blog post, but for now let me just summarize briefly: bottom line, if choose to be bearish and select the 105 strike put calendar, 5 points below the stock’s current price, it will usually cost less than the 115 strike call calendar, 5 points above the stock’s price. Since the maximum risk to the long calendar spread equals what you pay for the trade, the cheaper cost of puts means you ultimately risk less if you choose to be bearish.
Now before you run away with that notion, keep this in mind: it’s possible to lose more than what you paid for a long calendar if you are dealing with American-style stock options which can be exercised early. This “early assignment risk” of the short front-month is a big deal. If you’re considering trading long calendars in-, at- or out- of-the-money, my post about early exercise is a must read! It explains in painstaking detail the early assignment risk posed by potential dividends to any long call calendar spreads you’re holding. It also explores the fact that puts are more likely to be assigned early than calls – and why that’s true. You must understand early assignment risk if you choose to trade calendars because you’re dealing with options of different expirations. Y
Next week brings another twist to this theme: diagonal spreads. It’s a calendar spread in that the expiration months are different, but the strikes are also slightly different. Stay tuned next week for what diagonals can add to your bag of tricks.
Regards,
Brian (OG)
[image: Thums Up by Meanest Indian on flickr]
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
Any strategies discussed or securities mentioned, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities.