If a stock is soon to make a major move, either to the upside or downside, a short calendar spread is one method to profit from the price change. The derivative strategy has limited profitability, which is capped at the net credit earned, less commissions. The potential loss in theory is unlimited when using calls and considerable when using puts.
Making a Short Calendar Investment
The short calendar spread can be used either with calls or puts, but not a mix of them. With this strategy, you buy one contract while simultaneously selling another. Both options have the same underlying stock and strike price, and they should both be at-the-money. The written contract has a longer expiration date, by a week, a few weeks, or a month. Because the contracts have different expiration dates, the strategy is called the calendar or time spread.
With a larger amount of time value, the written contract is more expensive. Thus, entering the short calendar should produce a net credit.
Short Calendar Example
Suppose you hear in the news that Biogen, a major player in the biotech industry, will be releasing the results of a study on an experimental drug for the treatment of multiple sclerosis. If the results are favorable, you expect the stock to experience a major upswing, but if the results are a disappointment, the stock price will probably see a drop.
You want to be able to profit regardless of which direction the stock heads. Knowing that the short calendar play will earn money in either direction, as long as the stock does make a move, you decide to take a short calendar position.
Biogen is currently priced at $286 in the open market. You decide to trade put options. You sell one put contract with a strike price of $285 and simultaneously buy a put option with the same strike price. The written contract expires one week after the purchased contract. It sells for $700, while the purchased contract has a $500 price tag. Thus, the net credit for the option play is $200.
The results of the study are released, and there is no difference between the drug and a placebo. The stock price drops quickly to $250 and hovers there. Because both contracts are put options, they both increase in value; and since they both have the same strike price, they will experience similar increases.
You decide to sell the contract you hold and realize a profit. You receive $3,800. The short contract is still live, and you receive an exercise. This forces you to buy 100 shares of Biogen for $28,500, which you immediately sell for $25,000. This produces a loss of $3,500 on the short contract. Subtracting the loss from the $3,800 gain on the long contract produces a profit of $300 on the long contract. Adding this to the net credit you received at the outset produces a total gain of $500.
Gains and Losses
The short calendar strategy with puts becomes risky whenever the stock price declines, the long contract expires, and then the stock price goes down even more. This situation will increase the intrinsic value of the short contract. If you’re concerned about this issue, you can mitigate this type of risk by keeping the gap in expiration dates to a week, rather than a month. This gives the stock less time to decrease after the first contract expires.
Using the spread with call options could result in a similar situation if the stock increases in value, the first contract expires, and the price continues upward. This situation would increase the value of the second contract, outweighing whatever you made on the first contract at expiration.
Related Topics: calendar spread