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Friday September 03, 2010 |
Advanced Strategies for Options -
Horizontal Spreads - Neutral Calendar Spread
In
the last lesson we talked about vertical spreads and their
application. In this
lesson we're going to tackle horizontal spreads.
A
horizontal spread is one in which the calls have the same strike
price but different expiration dates. A simple example would be to buy the ABC July 25 call and
sell the ABC Jun 25 call. Why
would anyone want to do this? It's important to remember that the basic premise of
spreading is to offset the risk and the cost of buying a
particular option contract. When
an investor spreads time risk and cost are reduced.
Neutral
Calendar Spread
The
calendar spread is the most basic of horizontal spreads so we will
use this as a building block to discuss the more advanced
strategies.
In
a calendar spread position the investor sells one option and
simultaneously buys a more distant option with the same strike
price. The strategy
behind this neutral position is that time will erode the value of
the near term option and a faster rate than it will for the more
distant option. As
the spread widens the investor realizes a profit. In this neutral strategy the investor should initially have
the intent of closing the position by the time the near month
option expires. Let's
run through a quick example.
Nathan
believes America Online (AOL) common shares are likely to trade in
a narrow range for the next month. As he is scanning the option chain
online he notices that
an opportunity exists to execute a calendar spread. With AOL shares trading at 70 Nathan sells the one contract
of the AOL February 70 call for $5 and buys one contract of the
AOL May 70 call for $8 for a net debit of $3 per contract or $300. This strategy is neutral but let's examine what happens
at the February expiration.
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AOL
Share Price at Expiration
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February
70 call price
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Profit
for February 70 calls
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May
70 call price
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Profit
for May 70 calls
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Total
Profit
|
|
55
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$0
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$500
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$1
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($700)
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($200)
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60
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$0
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$500
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$3
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($500)
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$0
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65
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$0
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$500
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$3.50
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($450)
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$50
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70
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$0
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$500
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$5
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($300)
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$200
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75
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$5
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$0
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$8
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$0
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$0
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80
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$10
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($500)
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$12
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$400
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($100)
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85
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$15
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($1000)
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$16
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$800
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($200)
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As
we can see from this example the calendar spread is a very
effective strategy at most strike prices for the near month
expiration. Nathan begins to run into trouble when the stock price rises
substantially. If
this occurs the premium will erode for the distant month contract
and his profits begin to dwindle. After the February expiration Nathan could liquidate this
long position in the May 70 calls or he may choose to continue to
hold. If he chooses
the latter he risks losing any profit he may have earned from the
calendar spread.
Summary
1. A calendar spread produces a sweet spot. The nexus of the sweet spot is generally the strike price
of the short call position, in our example this is the 70-dollar
strike price.
2. Losses widen if the stock either rises or falls
significantly because the premium shrinks for the long call
position.
3. Risk is limited to the amount of the initial debit.
4. The width of the profit range is a function of the
volatility of the underlying stock and the time remaining for the distant month option since this will determine the value of
the remaining long call option at expiration.
5. Neutral calendar spreads have limited profit
potential and it is generally best to establish a calendar spread
eight to twelve weeks before the near month option expires.
butterfly
spread 
bullish calendar spread
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Home > Education > Using Options > Advanced Strategies >
Horizontal Spreads > Neutral
Calendar Spread
