Many stock investors are fearful when it comes to trading options. Horror stories abound on financial message boards about traders who were wiped out or took huge losses when venturing into the options arena. While these stories are likely true, it’s critical to note that the losses are due to the investor’s inexperience or disregard for the risky nature of options. Like in all types of investing, risk is part of the game in options. Knowledge is what prevents fear and turns options into profit making tools.
The good news is that by understanding the variety of option strategies, options can be used to actually reduce or control risk in the stock market.
One of these highly effective risk controlling strategies is called a Calendar Spread. This strategy involves the combination of a risk-reducing spread trade with the profit making opportunity of a directional trade in the same trade. Calendar Spreads truly give the power to option traders!!
The cool thing about Calendar Spreads is their flexibility. Calendar Spreads can be used in multiple market conditions.
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First, this type of spread can be a market neutral position that can be extended ( rolled over) to cover the cost of the spread while taking advantage of time decay. As you likely know, time decay is the bane of option buyers. Every day that passes for option buyers reduces the price of the option. The blunt weapon method of taking advantage of time decay is to be an option seller. While selling options can create a steady stream of income, the risk level is very high when selling naked. Naked means to sell a put or call without any type of hedge that will protect your equity should the option take off on the upside. Even professional option traders sometimes get burned when selling options. I know of several large hedge funds that were nearly wiped out when their option selling programs hit black swan style adverse market conditions.
The great news is Calendar Spreads allow you to take advantage of time decay without the outright risk of selling options.
Secondly, Calendar Spreads can be used to initiate short term market neutral positions that have a longer timeframe directional bias yet can participate in unlimited upside potential.
Prior to explaining how simple it is to create and profit from Calendar Spreads across different market conditions, let’s first look at the basic building blocks of the Calendar Spread.
A Primer On The Basic Components of a Calendar Spread
Calendar Spreads are built on buying and selling puts and call options; a put option is purchased if you expect the underlying stock to go down. Traders sell put options when you expect the underlying stock to climb in value.
Call options profit when the underlying stock increases in value. Calls are sold when you expect the underlying stock to fall in value.
Each option symbolizes 100 shares of the stock and has a limited lifespan. Options are characterized in a code like arrangement that consist of the root symbol + expiration month code + strike price.
Options are characterized in a code like arrangement that consist of the root symbol + expiration month code + strike price.
Just what do these terms mean? The root symbol refers to the stock symbol but is not the same as the ticker symbol. Root symbols can be found by looking at the options available for each stock via your broker or one of the many free option information services on the web. The expiration month code is the code for the month the option expires—January through December. Options normally expire around the 15th of each month for that month. Strike Price is the price where the option begins to have intrinsic value, meaning actual worth and simply not just time value. If the option has a strike price greater than the price of the stock, a PUT is said to be “in the money” and a CALL would be “out of the money” and vice versa. Here is a chart illustrating the options codes.
This information is critical to know when choosing options for calendar spreads.
|Strike Price Codes|
Calendar Spreads Explained
The easiest to understand Calendar Spread is known as the time spread. It is the buying and selling of a call or a put of the same expiration price, yet different expiration months. The way it works is you sell the short-dated option and buy the long-dated option. In other words, you want to buy the time premium inherent in the option that has a further away expiration date and sell the time premium in the option that expires sooner. Your account will experience a net debit on the trade, but this debit is reduced by the sale of the short dated option. Advanced traders can work this spread in a variety of ways as expiration draws closer.
Calendar Spreads can be used with either puts or calls. If you are bullish on the underlying, use calls. If your bias runs bearish, utilize puts for the spread.
The ideal end game for the spread is for the underlying to expire at the strike price of the options. Locating stocks that are trading long term in tight channels are the ideal stocks for this strategy. Calendar Spreads makes the most sense for traders who have a short term neutral bias but a bullish longer term bias. The bet is that the short dated option expires out of the money and you get to keep the premium. This leaves you with a long call that has some time prior to expiration.
Now, if you maintain your neutral bias upon expiration of the short dated option, you can sell another one to create another credit to your account.
Here Are A Few Hints
1. Leg Into Time Spreads
You don’t need to put on a time spread all at once. If you own puts or calls and the underlying is flat, you can always create a time spread to created income.
2. Timing is Critical
Think of the spread as a covered call. This means its best to go at least three months out for the long dated option. At the same time, sell the earliest expiring option to create income with the least risk.
3. Be Aware of Risk
Always be prepared to lose the maximum possible on the trade. This way you are prepared for the worst situation and can position size to control your overall account risk factor.