“Another day older and deeper in debt.” How many of us have heard this little tidbit and thought to ourselves…”There has got to be a way to change that trend?” Well, instead of the passage of time digging us deeper into a hole from interest charges, mortgage loans, college costs, medical bills, etc. etc. etc.; let’s turn the tide and have the same passage of time PAY us!
Stocks will be doing one of three things at any given time: They go up, they go down, or they go sideways. Profiting from the up or down trends is pretty straight forward, but when it comes to sideways, things get a little less clear. If a stock is going nowhere, how can we make money from it? The magical answer to that question is a strategy called a time spread or calendar spread. Calendars are one of many strategies used in a sideways market.
The passage of time is a law of nature. It is impossible to stop it. We can’t even put it on hold! Yes, you are getting older every single day. Sorry to be the bearer of this bad news. To ease the pain of age creeping in, we can capture time decay (the value an option loses per day). What you do with it after you’ve captured it is completely up to you. I’ll warn you though, it’s not quite like saving time in a bottle. (I don’t think Jim Croce had calendar spreads in mind when he wrote that song.)
A calendar spread is an option strategy where we sell a short term option and buy one at the same strike price expiring later. For instance, selling an Aug 50 call and buying a Sep 50 call. The difference in expirations allows us to capture the quicker time decay in the short month, while the longer expiration maintains more of its value. Time decay in an option is somewhat exponential in the last 30 days prior to expiration. This exponential decay is where the calendar spread profits.
By trading both options at the same strike price, we hedge the directional risk in the trade to some degree. Of course, if the stock moves in a directional way significantly, the calendar spread will be hurt. Ideally, the stock will hover around the strike price until expiration of the short leg. If the short leg expires at or out of the money, it will expire worthless. The long leg of the spread will still have some of its time value left. Options that are at-the-money have the most time value, so the stock ending right at the strike price we trade would maximize our gains. How often can we predict the precise price a stock is going to be on a given day? Never! So we do the next best thing and find a stock trading sideways in a channel around the strike price we select.
Let’s look at an example of this trade in action. As we walk thru this example, remember that this is just for education and informational purposes. No recommendation should be implied. Commissions are excluded for this example.
Here is a 3-month chart of Johnson & Johnson (JNJ). If you notice from mid May thru mid June the stock was moving sideways around the $55 price range.
As you can see, our cost at entry is $700. As the stock continues cycling sideways, the time decay of our June options happens at a faster rate than the July. Upon exit, we brought in a net gain of $250, which is a return of just over 35% on our investment. Not a bad return for a month.
The exit was a couple of days prior to the June expiration. Getting out just a bit early when the stock is very near your strike price will prevent the options being exercised unexpectedly.
The example we went thru is called a back to back calendar. This is referring to the expiration times being only a month apart. A long term calendar would be a trade in which the sold contract is still the near term expiration, but the one bought is out several months in time. It is essentially setting the trade up to sell more than just once. After the initial short leg is closed, the next month is sold, and so on until we get to the month prior to the long leg expiration. The challenge with a longer term calendar spread is finding a stock that will remain range bound for extended periods.
Well, I won’t say that calendar spreads are the fountain of youth. But, in a way, the strategy allows us to “save time in a bottle”, or at least add profit to our accounts from the passage of time. One last friendly reminder, another day older…isn’t always a bad thing. Happy trading!
You can learn more about different option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here.
And be sure to check out our new Zacks Options Trader.
Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
