Calendar call spread
Calendar spreads are known as horizontal spreads, and the Calendar Call is a variation
of a Covered Call, where you substitute the long stock with a long-term long call
option instead. This has the effect of radically reducing the investment, thereby
increasing the initial yield. However, this initial yield is not necessarily reflective of
the maximum yield at the expiration of the short-term short call. The maximum yield
will depend on both the stock price and the residual value of the long unexpired call.
The problem with a Calendar Call is in the very essence of the shape of the risk
profile (see the following). What we?d like to do is create something similar to a
Covered Call, but with a better yield and without the expense. The Calendar Call
certainly requires less investment; however, the shape is different. If the stock rises
too far too soon, then the Calendar Call can become loss-making. So even though
you got the direction of the trade right, you could still lose money! This happens
because the long call, being near the money, only moves at around half the speed as
the underlying stock as the stock price rises. This means that in the event of exercise,
if the stock has risen by, say, $10.00 from $30.00, and your option has only risen by
$5.00, you may be exercised on the short call; therefore you buy the stock at $40.00
and sell it at $30.00 (if that was the strike), yet your long call has only risen by $5.00,
giving you a $5.00 loss. If you only received $2.00 for the short call, you?re looking
at a $3.00 loss on the trade.
Both options share the same strike, so if the stock rises above the strike, your
short call will be exercised. You?ll then have to sell the long call (hopefully for a
profit), use the proceeds to buy the stock at the market price, and then sell it back at
the strike price. Therefore, the best thing that can happen is that the stock is at the
strike price at the first expiration. This will enable you to write another call for the
following month if you like.
Steps to Trading a Calendar Call
1. Buy a long-term expiration call with a near the money strike price.
2. Sell a short-term call (say monthly) with the same strike price.
Steps In
Try to ensure that the trend is upward or rangebound and identify clear
areas of support and resistance.
Steps Out
Manage your position according to the rules defined in your Trading Plan.
If the stock closes above the strike at expiration, you will be exercised. You
will sell your long call, buy the stock at the market price, and deliver it at
the strike price, having profited from both the short option premium you
received and the uplift in the long option premium. Exercise of the short
option is automatic. Do not exercise the long option or you will forfeit its
time value.
If the stock remains below the strike but above your higher stop loss, let
the short call expire worthless and keep the entire premium. You can then
write another call for the following month.
If the stock falls below your lower stop loss, then either sell the long
option (if you?re approved for naked call writing) or reverse the entire
position.
Outlook
With a Calendar Call, your outlook is neutral to bullish. You expect a steady
rise.
Rationale
To generate income against your longer term long position by selling calls and
receiving the premium.
Net Position
This is a net debit transaction because your bought calls will be more expen-
sive than your sold calls, which have less time value.
Your maximum risk on the trade itself is limited to the net debit of the bought
calls less the sold calls. Your maximum reward is limited to the residual call
value when the stock is at the strike price at the first expiration, less the net debit.
Effect of Time Decay
Time decay affects your Calendar Call trade in a mixed fashion. It erodes the
value of the long call but helps you with your income strategy by eroding the
value faster on the short call.
Appropriate Time Period to Trade
You will be safest to choose a long time to expiration with the long call and a
short time (one month) for the short call.
Selecting the Stock
Choose from stocks with adequate liquidity, preferably over 500,000 Average
Daily Volume (ADV).
Try to ensure that the trend is upward or rangebound and identify clear areas
of support and resistance.
Selecting the Option
Choose options with adequate liquidity; open interest should be at least 100,
preferably 500.
Look for either the ATM or just OTM (higher) strike above the current
stock. If you?re bullish, then choose a higher strike; if neutral, choose the ATM
strike.
Look at either of the next two expirations for the short option and
compare monthly yields. Look for over six months for the long option.
Risk Profile
Maximum Risk Limited to the net debit paid
Maximum Reward [Long call value at the time of the short call expiration,
when the stock price is at the strike price] [net debit]
Breakeven Down Depends on the value of the long call option at the time
of the short call expiration
Breakeven Up Depends on the value of the long call option at the time
of the short call expiration
Advantages and Disadvantages
Advantages
Generate monthly income.
Can profit from rangebound stocks and make a higher yield than with a
Covered Call.
Disadvantages
Capped upside if the stock rises.
Can lose on the upside if the stock rises significantly.
High yield does not necessarily mean a profitable or high probability
Exiting the Trade
Exiting the Position
With this strategy, you can simply unravel the spread by buying back the calls
you sold and selling the calls you bought in the first place.
Advanced traders may leg up and down as the underlying asset fluctuates up
and down. In this way, you can take incremental profits before the expiration
of the trade.
Mitigating a Loss
Unravel the trade as described previously
Advanced traders may choose to only partially unravel the spread leg-by-leg.
In this way, they will leave one leg of the spread exposed in order to attempt
to profit from it.
Example
ABCD is trading at $65.00 on May 5, 2004, with Historical Volatility at 30%.
Buy January 2006 65 strike calls at $12.50.
Sell June 2004 65 strike calls at $2.70.
At June Expiration
1. Scenario: stock falls to $60.00
Long calls worth approximately 8.40; loss so far = 4.10
Short calls expire worthless; profit 2.70
No exercise
Total position = 12.50 + 2.70 4.10 = 11.10 = loss of 1.40
2. Scenario: stock falls to $62.50
Long calls worth approximately 9.80; loss so far = 2.70
Short calls expire worthless; profit 2.70
No exercise
Total position = 12.50 + 2.70 2.70 = 0.00 = breakeven
3. Scenario: stock stays at $65.00
Long calls worth approximately 11.40; loss so far = 1.10
Short calls expire worthless; profit 2.70
No exercise
Total position = 12.50 + 2.70 1.10 = 14.10 = profit of 1.60
4. Scenario: stock rises to $70.00
Long calls worth approximately 14.80; profit so far 2.30
Short calls expire $5.00 ITM
Procedure: sell bought calls; buy stock at current price and sell at strike price
Exercised at $65.00
Buy stock at 70.00
Sell stock at 65.00
Loss 5.00
Sell long call for a profit 2.30
Keep short call premium 2.70
Loss on Exercise = 5.00
Total position 0.00 breakeven
5. Scenario: stock rises to $75.00
Long calls worth approximately 18.35; profit so far = 5.85
Short calls expire $10.00 In the Money
Procedure: sell bought calls; buy stock at current price and sell at strike price
Exercised at $65.00
Buy stock at 75.00
Sell stock at 65.00
Loss 10.00
Sell long call for a profit = 5.85
Keep short call premium 2.70
Loss on Exercise 10.00
Total position 1.45 loss
Never exercise a long-term option because you will miss out on Time Value!
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