When you are fairly neutral on the market and you want to generate additional income
from your investments, there is an option strategy that is worth your consideration. This strategy involves selling an option with a nearby expiration, against the purchase of an option (with the same strike price) which has an expiration date that is further out.
A Calendar Spread is an option spread where the strike prices are the same, but they have different expiration dates. These spreads are also referred to as:
Horizontal trade
Delta neutral trade
Sideway trade
Non-directional trade
Time spread
Calendar spreads can provide a way to add value to your portfolio through your purchase of a long term option with a reduced cost basis, provided by a near term option that you sold.
One very favorable point to a Calendar Spread is the value of time decay. Although both options lose time value as time passes, the option you sold loses value much more quickly than the option you bought. Therefore, if your prediction of a neutral market is correct, the value of your Calendar Spread will increase as time passes. A Calendar Spread takes advantage of time value differentials during neutral markets.
When the near term option expires, you have several alternatives. If you are still predicting a neutral market, you can hold on to your long position, if there is sufficient time left on it, and sell another short term option against that long position. If you are dealing in calls and you fear that the market may go down, you can close out your long position and take the profits. If you are dealing in calls and you predict a more bullish market, you could just hang on to your long position and take a larger profit in the future. In any of the cases, your cost basis on your long position was reduced by the premium you collected from the option you sold.
It is also important to cover risks and caveats of this strategy. Your loss is limited to the net premium you paid (the money you paid for the option you purchased minus the money you received for the near-term option you sold.
There are many different ways to implement a Calendar Spread, depending on your goals and your market outlook. When we implement spreads of this nature, we try to buy long term options that are undervalued.
One popular implementation of the Calendar Spread is try to generate income similar to a Covered Call strategy, but involves buying LEAPS (Long Term Equity Anticipation Securities) instead of the actual stock. So calls are sold against the LEAPS instead of the actual stock. This is done because the LEAPS can be purchased much more cheaply than the actual stock, which can generate much higher returns on invested capital. The risk with this implementation is that the underlying stock goes down in price instead of staying neutral, causing your LEAPS to go down in value. If the underlying stock goes up in price at expiration of the near term option (instead of staying neutral), you could buy back the option you sold and then sell another option, one or more months out.
When you implement this type of spread, you are hoping that the near term option you sold expires worthless. Then you can sell more options a little further out and continue to collect more premium. This either decreases the cost basis of the LEAPS you purchased, or produces recurring income for you.
It is important to analyze your expectations for the underlying asset and for the market before selecting your strategy.
