Even if you aren’t that familiar with options, I’ll bet you’ve heard someone use the term ‘calendar spread’.
Whether they knew what they were talking about is another story.
So let’s define it here.
Definition
A Calendar Spread (also known as a ‘time spread’ or ‘horizontal spread’) is when you sell (write) an option in one month and buy an option with the same strike price but in a different, further out month.
Since the option you’re writing has less time (worth less) and the one you’re buying has more time (will be worth more), this can also be referred to as a debit spread as well.
You can do this with puts too – sell a put in a nearby month and buy the same strike in a further out month.
As you would expect, you’d have a neutral-to-bullish bias with the calls and a neutral-to-bearish bias with the put.
You can also ‘sell’ this strategy as well by buying the nearby and selling the further out – but today, let’s keep our focus on the long side.
Example
Let’s use IBM (IBM) for this example.
- Let’s say you wrote the July 130 call for 3.00 (collect $300)
- And let’s say you bought the October 130 call for 6.85 (paid $685)
- net cost (debit) is 3.85 or $385
Why Would I Want to Do This?
The maximum potential loss is limited by what you paid for the spread – in this case $385.
The maximum profit if removed together would be the difference between the two option prices at the expiration of the nearby month.
Let’s say IBM closed below $130 when the July options expired.
- At expiration, the July 130 call I wrote for $300 is now worth $0
- And the October 130 call I bought for $685 is now worth $560
- my calendar spread is worth $560
$560 less than my cost of $385 = profit of $175 or a 45% profit
If I wanted, I could decide to hold onto that further out call if I thought a rally was underway – and make even more money.
But of course, if it went down, I could lose the rest of the premium. But again, my maximum loss would be limited to $385.
This is a great strategy.
Granted, you’re limited in your profit potential, but you’re capitalizing on the dynamics that the nearby month will lose its value (time value) quicker than the further out one.
Some people probably don’t bother with this strategy because the profit potential seems small. But if you look at it in percentages, a 30%, or 40%, or in this case a 45% return isn’t small at all. If you put ten of these on for example, before commissions, it would cost $3,850. If you made $175 profit on each one, that’s a $1,750 profit or 45%.
And that’s pretty exciting.
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.
