As an alternative to the butterfly, a calendar spread gives you the ability to sell extra premium against a stock when it is used in combination, as we are doing. Like a butterfly, a calendar spread can be used as a bearish, bullish, or neutral trade. In our model, we will use it as a neutral trade and a bullish trade. We do like using it as a slightly bullish trade also.
Let’s start by talking about the neutral approach. If you use just the calendar spread as a short-term trader, a neutral approach would be to use at the money options.
For example, if XYZ stock is trading at $50, you could sell the front month $50, you could sell the front month $50 call and buy a four-month $50 call. Your hope is that the stock stays as close to $50 as possible. That way, the premium you continually collect for the next three months would be greater than the premium you had to pay for the four-month call. This is a good strategy for a neutral, short-term trader to consider. However, how could this benefit long-term investors?
The answer is potential extra income. If we just did a calendar spread alone we would have premium risk. We don’t want to have too much of that in a the long-term account. By letting the covered call premium finance the calendar spread, we create our defense against premium risk.
If XYZ stock is at $50 and we are very neutral, we could buy the two-month $50 call for $2 and sell two front-month $50 calls for $1 each (one against the 100 shares of stock we own, and one against the call). Our goal is to get enough premium for the short calls to finance the cost of the long call. That way, if the stock is below $50 at expiration, we have a free call option at $50.
At that point, we can do whatever we like. We could sell the option and take the cash we could roll the option, or we could create another spread of some sort. The possibilities are endless.
My preferred way of doing this would be to go out of the money on the ratio calendar spread. If the stock is at $50, I would want to own 100 shares of stock, sell two $55 calls in the front month for 50 cents each and buy one $55 call at $1.25 for the second month. That way, we allow for a pretty nice profit to occur if the stock increases (even above the $55 mark).
If the stock stays below $55, we would now have a very inexpensive call at the $55 mark upon the expiration of the first month. Overall, the cost of the debit we would incur is 25 cents. The short $55 calls would expire worthless, even if the stock increases 10%. Then, we have a choice of having cheap double leverage at $55 or selling the stock when it gets to $55. That way, we could take away all stock price risk, but we still get to participate in the reward. If you go out of the money, there is a greater chance of incurring a debit, but the debit would be less than just buying the call itself.
Check back for our next post explaining an interesting concept for the out of the money calendar ratio.
