An Options Strategy The Rolling Stones Would Love

“Time, time, time is on my side.”

So say the Rolling Stones in the famous song they recorded in 1964.  Many newer options traders have put themselves in a situation where the exact opposite is true.  They put on too many trades which can turn the ticking of the clock into a stressful event rather than a savvy way of putting time on your side.  It is time to consider using the Calendar (also called, Time or Horizontal) spread.

This is a spread that is often used by both newer and very experienced traders and along with vertical spreads is a primary building block of more complex spreads.  These spreads have many of the characteristics that traders love in an options trade since they have low capital requirements and the one thing that should be determined in every trade, defined risk.

The reason for this designation is that you are, when purchasing the spread, buying the calendar.  You are selling the nearer term option and purchasing the further term option.  As the nearer term options decay at a faster rate (theta) than the further option, this will allow you to benefit from that decay.  This trade structure can be used to speculate on market direction or as a market neutral strategy.  In our example we will talk about a spread with a market basis.  The position can achieve its maximum profit if the underlying price settles at the strike price of the short option at expiration.  Here is an example to clarify this position.

Let’s focus on IBM from March 18, 2013.  As you can see in the table below (click to enlarge) the stock was trading at 214.13 on our example time and date.  The options I want you to focus on are the highlighted April 205 put and the May 205 put.  This position is going to have a directional bias, as we are going to simultaneously purchase the May 205 put and sell short the April 205 put.  If we were to do this trade it would cost us $0.95 per share, plus transaction costs.   We spoke of the max profit, but first we’ll define max loss. The max loss on this trade would be what you pay for the spread or the full $0.95.

As we mentioned above you would like to see the price of IBM go to the strike price of the front month for maximum profit, in other words you would like IBM to be at 205 at the end of trading on April 19 which is April options expiration day.  If IBM closes at 205, the April put, the one we are short, will expire worthless.  Meanwhile, the price of the May put, which we purchased, will have its maximum time premium, since it is “at the money” with IBM at 205. Keep in mind that since these options have the same strike price their intrinsic value will always be exactly the same.  One golden rule of options is the at the money call and at the money put have the greatest amount of time premium but little to no intrinsic value.  In other words if IBM closes at 205 at expiration, the April option contract will expire worthless but the May option will have the greatest time premium of all options in that month and the spread expands.

There are a few things to keep in mind that may help you in considering this strategy.  This is a trade that can benefit from volatility going higher.  The further out on time an option is, the greater the option’s reaction to movement in volatility (an options reaction to volatility is vega). A very important factor to keep in mind as you select your strikes, you would want to pick the strike price by selecting the strike that is nearest to where you believe the stock will close at the expiration of the near term short options or where you think the stock will be on April expiration.  This can be used as more target trading.

Looking at our example, this trade would have a bearish bias as we have targeted 205 for our strike price.  A rule of thumb in terms of direction on these trades: if you think the underlying stock is going higher, consider a call calendar spread, if you think lower, a put calendar spread and if you think we are staying the same buy, either the at the money call or at the money put calendar spread.  You may have noticed that I talk about considering out of the money spreads.  The reason for this is the nearer term option that you are selling is then out of the money which reduces the initial probability that the option will be exercised by a counter party and you will have the option assigned.  As you look at this, you may notice I used a one month spread and passed over weekly options and only went for a length of one month.  You can absolutely use the weekly options or have a 2 or 3 month spread if desired.  In order to keep our example simple we wanted to have a one month but please keep in mind as you develop your skills there are many more ways to play this.

As you think about both placing and unwinding the trade, many newbies try to do these as two separate trades, as you start out and get used to mechanics, think about trading as one spread.  If you do trade as a spread, it has to fill on the whole thing; the counterparty cannot just take one side of the trade and leave the other.  This can be particularly important when unwinding the trade, as if you simply take off the near term option or let it expire, you are then long a naked option.

Being long a naked option may not be a bad thing on its own, but it puts you in a different risk scenario, and is not the point of your original trade.  One other thing to note is I did not mention selling a Calendar spread at any point in this post.  Thinking about the mechanics of selling a put spread, you would buy the nearer term and sell the farther term options.  In our example we would have purchased the April 205 and sold the May 205 put.  This would mean that after April expiration you would be naked short a put.  Being naked short an option, puts you in a completely different risk category and you would want to be sure you understand all of the implications of doing so.  Being naked short options is a completely different risk profile and as with all trades the risks should be completely understood before being entered into.  Remember we always like to think about risk defined spreads.

As we are operating in what is considered a low volatility environment, finding ways to take advantage of even small lifts in volatility becomes more important.  Putting yourself in a situation where you can do so while at the same time being able to take advantage of option premium decay is an interesting concept.  The Calendar Spread is so interesting as it can be used  as a building block for more complex strategies, making it an important tool in your trading toolbox.

Options involve risk and are not suitable for all investors.  Before trading options, please read Characteristics and Risks of Standardized Options.

Spreads and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return.  Transaction costs (commissions and other fees) are important factors and should be considered when evaluating any options trade. Commentary and examples provided for educational purposes only.  Should not be considered a recommendation for any specific security or strategy.