Trading is all about exploiting opportunities as they come. And option trading is chock full of opportunities because of the multiple price influences that can each be exploited. One of the opportunities option traders can take advantage of is time and its effect on option prices.

Time Decay

All options have a limited life. As the useful life of an option decreases, so does its value—all other factors held constant. This phenomenon is known as time decay. Trading calendar spreads offers a way to capitalize on time decay while providing limited risk.

Trading Calendar Spreads

A calendar spread involves buying one call option (or put option) and selling another call (or put) on the same underlying, with the same strike price but with a shorter term to expiration. Here’s an example.

Imagine a stock is trading at $50. You believe this stock will trade in a narrow range for the next 30 days. This could be a good candidate for a calendar spread. In this example, the January 50-strike calls (which expire in one month) are trading at 2.30 and the March 50-strike calls (expiring in three months) are trading at 4.10. We can construct a calendar spread by buying the March option and selling the January. Here we are “buying the calendar” for a 1.80 debit (4.10 – 2.30). (*Please note, this example does not include commissions).

OK, so how do calendar spreads benefit from time decay? At-the-money options decay at a “non-linear rate”, meaning options with less time to expiration lose their value at a faster rate, often a much faster rate, than comparable longer-term options. A trader can capitalize on the rapid rate of time decay, or theta, by selling the short-term option while hedging directional risk by purchasing the long-term option.

What happens if the posiiton is held  until expiration?

It is interesting to look at what happens both below and above the strike at expiration of the one-month call. If the underlying stock is below the strike price at January expiration, the January call expires. You are left with a long position in a 50-strike call that now has two months to expiration—a bullish position. This call has an effective purchase price of 1.80 (the 4.10 originally paid for the long call minus the 2.30 of premium received on the sale of the short call).

With the stock above the 50-strike at expiration, the short call will be assigned, which will create a short position in the underlying stock, and you are still left with the long 50-strike March call with two months to expiration. This is a synthetic long put—a bearish position. 

The best-case scenario is that the stock is trading right at 50 at expiration of the January call. Here, the January call expires, profiting the entire 2.30 premium collected upon its sale. The March call would lose less, say only about .80 to time decay. In this case, the position has a maximum net profit of about 1.50, all else held constant. From a directional perspective, this is the maximum value the remaining call can have without the short call being assigned and incurring potential losses associated with the assignment above the strike. 

If your forecast on the stock is slightly bullish, you can construct a calendar spread using out-of-the-money calls. This allows for the long call to profit from an upward movement in the underlying without the short call being assigned. The key is that the stock moves up to, but not through the strike price. When deciding on which strike to purchase a calendar spread, it is best to select the strike at which you believe the stock will be at expiration or upon exiting the position.

At January Expiration

At some point in time, whether it is on expiration day or before, the January call will have little or no time value left. Ideally the stock is trading very near the strike. At this point, you can exit out of the entire position and take a profit (or loss) and move on to the next trade.

If, however, your forecast on the stock at this point in time continues to be neutral, you may want to roll out of your expiring call and sell another one-month call against the March call. If the short call has very little time left to expiration, the stock is still trading around $50 and volatility is unchanged, the one-month call you are rolling into should be trading fairly close to 2.30. If, after the passage of the next month, your forecast is, again, correct and the stock is trading at $50, you keep another premium of 2.30 and you are left with a long call position. You have now collected two premiums totaling 4.60. and you are left with a long position in a one-month call that you originally purchased for 4.10. 

This is a critical point. You can trade out of the entire position, taking your profit (loss) and move on to the next trade. You can roll further out in time on both the short and the long call, establishing a new calendar spread on this stock. Or, if you are bullish, you can simply do nothing, allowing the short call to expire and hold the March call already owned. In this particular example, in which the stock remains flat for two months, there is no risk in owning this one-month call. The worst-case scenario is that at expiration the March call is out-of-the-money and expires worthless. You still profit, overall, .50 (the total of 4.60 collected in premium on the two calls that have been sold over the last two months less the 4.10 originally paid for the long call).

It is important to note that the premium paid for the long call is not always “paid for” after collecting just two months of premium. Often times it will take several months of collecting time decay from selling options to finance the long option leg of the spread. Many traders will construct a calendar by selling the one-month option and buying an option with a much longer term to expiration, or even LEAPS® options. This way, if your forecast remains the same, you can continue selling one-month options against the same long position. If your forecast changes, you have the option of trading out of the entire position or holding the long, which at some point, will be owned “for free”. Furthermore, if the stock makes a big move in either direction, the trade can end up a loser instead of giving you the “free call”.

Wrap Up

Understanding calendar spreads creates a whole new set of opportunities for traders. It also helps traders understand options on a deeper level, helping them to trade other strategies with more knowledge and confidence.

For questions or to learn about mentoring with Dan Passarelli, contact him at [email protected] or visit his company website: MarketTaker.com.

 

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