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There are a great many options strategies available to the trader with a directional bias. For those bullish or bearish, respectively, on a stock, buying a call or put is the simplest option.
But selling calls and puts is another approach, and I’ve addressed the latter at length here. I’ve also discussed simple spread strategies for those who want to know precisely their trade’s risk/reward profile and feel more comfortable hedging their bets.
Today, we take another step toward filling out our directional bias toolbox with a look at calendar spreads.
Simple calendar spreads – also known as time spreads or horizontal spreads – are composed of two calls or puts on the same underlying security with the same strike but different expiration dates. And, as usual, there are different types depending upon whether you’re a bull or a bear.
Let’s take a look at them:
1. Bullish Call Calendar Spread
Let’s say Facebook (NASDAQ: FB) stock has been moving sideways for some time, but you expect it to leap higher after the company’s earnings report six weeks down the road. You look at a calendar and see there’s an option expiring three weeks before the earnings announcement and another expiring one week after. You want to be long the latter to take advantage of the ensuing pop, but you see a benefit, too, in selling the earlier call to reduce your costs.
Graphically, it looks like this:
Say it’s June 3 and the shares are selling for roughly $80 (black circle). You go ahead and sell the June 85 calls for $0.90 and buy the July 85 calls for $1.55, for a total debit of $0.65 per spread.
With the June expiry (first green circle) the stock is still meandering sideways (as you expected) and the option expires worthless. You now possess a discounted long July 85 call in anticipation of good earnings news … and you’re right!
Earnings day brings a blockbuster profit report after trading hours (in blue), and the following day the stock gaps higher, sending your calls nearly 10 dollars into the money. You cash out before expiry with a big win.
2. Bearish Put Calendar Spread
The same trade, of course, can be initiated if your outlook is bearish. Should you anticipate a sideways move followed by a drop in stock price, you can simply sells a near-term put and buy a longer-dated put with the same strike.
The principle doesn’t change, however. The goal of the calendar spread is to sell the near-term option with the hope that it expires worthless, reducing the cost of the latter long option, which you expect to move strongly in your direction.
Maximum risk for the calendar spread is limited to the initial premium paid.
Maximum reward occurs when the initial option expires worthless and the open, long option moves to infinity (if a call) or zero (if a put).
Important trading note: Remember, too, that if the long call expiry is several months away, near- term options can be sold against it on a weekly or monthly basis, as appropriate, thereby reducing one’s costs even further.
Happy hunting!