The Calendar Spread ~ Call and Put
Posted by sellacalloption
The calendar spread is an option strategy that involves
buying an option and selling an option simultaneously with the same strike
price, but different expiration dates. A calendar spread can be long or short. A calendar spread can be constructed with call options, put options or both which is known as a dual calendar spread.
A long calendar spread is done for a net debit and the risk is limited to the
amount of the debit. A short calendar spread is done for a net credit and is known as a credit spread. Investors can use calendar spreads to enter hedged stock or ETF positions. The long put calendar spread can be utilized to enter a long stock position with limited risk. If the investor has a market opinion that the underlying will stay below a certain strike in one month, and then rise the following month, a long put calendar spread may be a good choice, here’s how it works. XYZ stock is at 25, we think it will stay at 25 this month then rise next month with its earnings report. We’re going to sell the near term 26 put and buy a longer term 26 put. The net debit is $1. We’ll get assigned on the near term put, then hold a long stock position with an entry price of $27, but we have the right to sell it for $26 so our maximum loss is $1 and our maximum gain is unlimited. If xyz rises to $30 after the earnings report, we have a gain of $3 and have only risked $1. When there is a volatility skew between the expiration months, we can enter these positions with very tight spreads and very low risk. A volatility skew is defined as different expiration months have higher or lower levels of implied volatility. In the money options will have tighter spreads than at the money options, but will have a lower probability of success. Similarly the long call calendar spread can be used to enter a short underlying position with limited risk when one’s forecast calls for the underlying stock or fund to decline in value in the future. The spreads can be sold for a profit if the spreads widen or employed as a strategy to enter controlled risk positions for certain time periods. Calendar spreads can also be set up as diagonal spreads.
A typical diagonal spread will be long a far dated in the or at the money
option and will sell a near dated out of the money option. A diagonal spread
can be used as a covered call substitute with less risk and less capital outlay
than owning the underlying security. A long dated in the money call can be
purchased with a very long expiration like a LEAP and short dated current month or weekly out of the money options can be sold against the position for income.