If you expect a stock to remain in a neutral trading range for a few months, maybe because it isn’t set to release earnings or doesn’t have a history of volatility, then you might be able to earn a nice profit while stockholders earn little to nothing. With a unique option strategy, you can sell time, which is why the investment tactic is known as the long calendar spread.
Taking a Long Calendar Spread Position
The long calendar option spread can be entered by purchasing one contract and simultaneously selling another contract with a shorter expiration date. Typically, the contract you write should expire one week to one month prior to the expiration of the contract you purchase. Both contracts have the same underlying security and strike price, and the contracts should be at-the-money or just out-of-the-money. The options can be either puts or calls, but not a mix.
Profiting from the Long Calendar Strategy
Notice that in the long calendar spread, you take a short position on the contract that has the shorter expiration date. The time value of this contract should deteriorate more quickly than the time value of the contract with the longer expiration date. As the first expiration date approaches, the difference between the two contract values should widen, assuming the stock price has not made any significant moves, either to the upside or downside.
Bulls, Bears, and Risks
The primary risk with the long calendar spread is that the stock moves in the wrong direction, which will cause the contract you sold to have intrinsic value, leading to an exercise. If that happens, you will be left only with the contract you purchased, which will also have intrinsic value. You could either sell it on the open market, which would close out your derivative investment; or you could exercise it.
If you used a put spread, the long contract you hold will develop intrinsic value if the underlying stock turns south. Thus, you can have a bearish view on the underlying equity when using puts in the time spread. If you used calls, the contract you hold will increase in value if the stock heads north; so you can be bullish in your long-term expectations.
Example of a Long Calendar Spread
Kimberly-Clark (KMB) reported earnings last week while trading at $122. The data was in line with market expectations. You don’t foresee any major changes in the stock’s price, other than a gradual rise over time. You decide that a calendar spread with calls would be a safe method of earning some extra income.
You sell one call contract out-of-the-money for $350 with an October expiration date. At the same time, you buy another call contract, with the same strike price of $125, for $450. It expires in November. The total cost of the investment is $100. This net debit is the maximum loss the investment can produce.
If KMB hovers around $122, the short contract will be worthless at expiration. The long contract will decrease in value, but will still have some time value left in it. At this point you can sell the contract. If it has a market price of $300, the net profit on the investment will be $200 ($300 - $100).
If KMB increases to $130, the short contract will be exercised, but the contract you purchased will also rise in intrinsic value at the same time. If the stock declines to $105 at expiration, both contracts will have zero value, and the investment will be over, with the maximum loss of just $100.
Related Topics: Calendar Spread
