The Calendar Spread

Calendar spreads can be powerful tools if used correctly in your portfolio’s. What I really like about this strategy is that you are able to control a lot of stock with a much smaller amount of working capital, as well as the recurring income these trades can bring into your accounts. We will first look at the strategy, discuss the advantages and disadvantages, and then present a real time example of a trade for you too use as a guide.

The calendar spread is a bullish strategy. This strategy can be thought of as a covered call when instead of purchasing the stock you buy the LEAP instead. Setting up these trades is a two trade transaction. You will BUY a deep in the money call option and sell another call option at or around the current stock price. This transaction will always result in an initial debit transaction. Profit is made as the stock trades above your break even point. Many times these trades can be set up so that the stock at the time of purchase is already trading at or above the sold calls.

• Buy a long call at a given strike price (lower strike price).
• Sell a near month call zero or more strikes above #1 call.
• The net investment is the net debit (difference in premiums).
• The maximum risk is the net debit (difference in premiums).
• The maximum profit is realized if the stock is anywhere above the higher strike price. Maximum profit is equal to the value left in the bought option at the sold option expiration minus the net debit.
• The break even point is the point at which the value of the bought call will equal the net debit. A profit is realize at any price above the break even point.

Before we move on to show a real time example of this sort of trade let’s review both the pro’s and con’s of using a calendar spread to determine if this strategy is right for you.

Advantages of this strategy:

• This is a BULLISH strategy, the profit can only be realized when the stock price is above the break even point.
• Buying the LEAP in lieu of the stock can generally allow the stock to be controlled at a discount.
• Losses are limited to the net debit.
• No stock is actually owned. (Uncovered position).

Disadvantages of this strategy:

• If the stock goes very high gains are limited to the difference in strikes minus the debit.
• It is important that the difference in strike prices must be larger than the cost of the long call to assure a profit if assigned after the first write.
• It may be difficult to write a near term call for every write cycle.

Real time trade example:

In order to make this a little easier to grasp let’s set up a real trade which will walk us through all the steps. After going through this tutorial you will have all the tools you need to start trading these trades today!

Let’s look at Tyson Foods (TSN):

Here is a one year chart on the stock:

As you can see the stock has pretty good support right around the $18 level.

To set up a calendar spread you could buy the Jan. ’07 LEAP with a $7.50 strike price for $10.60 and sell the Nov. ’05 call with a $17.50 strike for $1.10. This transaction will result in a $9.50 debit.

What does that mean? Basically it means that if (TSN) is able to close out above $17.50 on November expiration that you will receive a credit of $10.00 (difference in strike prices). Should this happen, you will realize a $0.50 gain on a $9.50 investment for 5.3% return. Not too bad for about 45 days!

What if we are wrong and the stock drops to around $17 by November expiration. In this case, you would still own your bought Jan 07 calls, but your sold calls will just vanish from your account. This is not necessarily a bad thing. You then go out and sell another call against your LEAP’s, each time lowering the debit you have in the position.

The best case scenario for these trades is for the stock to close just under your sold calls so you can get the highest premium for your next calls you sell. If you can do this just one of two times before the stock finally closes in the money you can see your initial tartet return shoot from 5% to 20+% fast.

How?

Simple. Let’s pretend we can see into the future. Let’s say our sold calls just expired and here we are the Monday after expiration just holding our LEAP positions, and the stock closed out expiration at $17.40.

We look at our options and see the December $17.50 calls are now trading at $0.65. We go ahead and sell these calls and that reduces our total debit from $9.50 to $8.90. Now, should the stock close above $17.50 on December expiration our position is now going to bring in $1.10 on our total debit of $8.90. This realizes a 12.3% return. You can see how it only takes one of two of these follow on trades to really boost your return.

Sound too good to be true?

Well, let’s remember, the riskiest part of this strategy is that the stock can fall in value and continue falling making it harder and harder to sell additional calls on the stock. While this creates a bad situation, you are still less at risk than if you had just bought the stock, and you can always cut your losses by dropping the strike price on your sold calls.

Pick of the week:

Updated: Tuesday, July 25, 2006

5:30 PM EDT... Continental Airlines (CAL ) has had a pretty good track record lately. We are going to look at the September 22.50 / 20 bull call debit spread for 2.25 per contract. This trade will produce a 11.1% return with 22.2% downside protection!