Calendar Spread

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.

Sell Straddle

When the market has just made a dramatic move and you are expecting it to consolidate - you might consider selling a straddle. This strategy involves selling a call option and a put option on the same asset at the same strike price and expiration date. This gives you a known, but limited gain, but does expose you to unlimited risk - so you must be careful with this position and be confident of your assumptions. It is not suitable for all investors.

With this strategy, your gain is composed of the premium you received for the call and the put, less the commissions.

When we sell Straddle, the put and call that we sell are normally on over priced options that are at-the- money or close to it. We consider doing this after a dramatic move in the market, when we are expecting it to consolidate the move and digest its gains before moving again. Because of the dramatic move that was made, volatility is high, making the options we sell very expensive. Then as the market consolidates, volatility decreases and lowers the price of the options, increasing our profits when we buy back the options at a lower price to close our position. Decay also works in our favor with this position.

But be ready to buy back one of the options if there is any indication that the market will resume its trend or reverse direction. If it looks like the market will trend up, buy back the call; if it looks like the market will trend down, buy back the put.

It is also important to cover risks and caveats of this strategy.

The risk of this position is unlimited so you must be very careful. Remember that the commission you pay for this position will be higher because you are initiating two related option transactions.

It is important to analyze your expectations for the underlying asset and for the market before selecting your strategy.

Covered Call

The covered call is a strategy in which an investor writes a call option contract while at the same time owning an equivalent number of shares of the underlying stock. If this stock is purchased simultaneously with writing the call contract, the strategy is commonly referred to as a "buy-write." If the shares are already held from a previous purchase, it is commonly referred to an "overwrite." In either case, the stock is generally held in the same brokerage account from which the investor writes the call, and fully collateralizes, or "covers," the obligation conveyed by writing a call option contract. This strategy is the most basic and most widely used strategy combining the flexibility of listed options with stock ownership.

Market Opinion? Neutral to Bullish on the Underlying Stock

When to Use?

Though the covered call can be utilized in any market condition, it is most often employed when the investor, while bullish on the underlying stock, feels that its market value will experience little range over the lifetime of the call contract. The investor desires to either generate additional income (over dividends) from shares of the underlying stock, and/or provide a limited amount of protection against a decline in underlying stock value.

Covered Call

Benefit

While this strategy can offer limited protection from a decline in price of the underlying stock and limited profit participation with an increase in stock price, it generates income because the investor keeps the premium received from writing the call. At the same time, the investor can appreciate all benefits of underlying stock ownership, such as dividends and voting rights, unless he is assigned an exercise notice on the written call and is obligated to sell his shares. The covered call is widely regarded as a conservative strategy because it decreases the risk of stock ownership.

Risk vs. Reward

Maximum Profit: Limited

Maximum Loss: Substantial

Upside Profit at Expiration if Assigned: Premium Received + Difference (if any) Between Strike Price and Stock Purchase Price

Upside Profit at Expiration if Not Assigned: Any Gains in Stock Value + Premium Received

Maximum profit will occur if the price of the underlying stock you own is at or above the call option's strike price, either at its expiration or when you might be assigned an exercise notice for the call before it expires. The risk of real financial loss with this strategy comes from the shares of stock held by the investor. This loss can become substantial if the stock price continues to decline in price as the written call expires. At the call's expiration, loss can be calculated as the original purchase price of the stock less its current market price, less the premium received from initial sale of the call. Any loss accrued from a decline in stock price is offset by the premium you received from the initial sale of the call option. As long as the underlying shares of stock are not sold, this would be an unrealized loss. Assignment on a written call is always possible. An investor holding shares with a low cost basis should consult his tax advisor about the tax ramifications of writing calls on such shares.

Break-Even-Point (BEP)?

BEP: Stock Purchase Price - Premium Received

Volatility

If Volatility Increases: Negative Effect

If Volatility Decreases: Positive Effect

Any effect of volatility on the option's price is on the time value portion of the option's premium.

Time Decay?

Passage of Time: Positive Effect

With the passage of time, the time value portion of the option's premium generally decreases - a positive effect for an investor with a short option position.

Alternatives before expiration?

If the investor's opinion on the underlying stock changes significantly before the written call expires, whether more bullish or more bearish, the investor can make a closing purchase transaction of the call in the marketplace. This would close out the written call contract, relieving the investor of an obligation to sell his stock at the call's strike price. Before taking this action, the investor should weigh any realized profit or loss from the written call's purchase against any unrealized profit or loss from holding shares of the underlying stock. If the written call position is closed out in this manner, the investor can decide whether to make another option transaction to either generate income from and/or protect his shares, to hold the stock unprotected with options, or to sell the shares.

Alternatives at expiration?

As expiration day for the call option nears, the investor considers three scenarios and then accordingly makes a decision. The written call contract will either be in-the-money, at-the-money or out-of-the-money. If the investor feels the call will expire in-the-money, he can choose to be assigned an exercise notice on the written contract and sell an equivalent number of shares at the call's strike price. Alternatively, the investor can choose to close out the written call with a closing purchase transaction, canceling his obligation to sell stock at the call's strike price, and retain ownership of the underlying shares. Before taking this action, the investor should weigh any realized profit or loss from the written call's purchase against any unrealized profit or loss from holding shares of the underlying stock. If the investor feels the written call will expire out-of-the-money, no action is necessary. He can let the call option expire with no value and retain the entire premium received from its initial sale. If the written call expires exactly at-the-money, the investor should realize that assignment of an exercise notice on such a contract is possible, but should not be assumed. Consult with your brokerage firm or a financial advisor on the advisability of what action to take in this case. Basically this is call writing against a stock you own