Advanced Strategies for Options - Horizontal Spreads - Neutral Calendar Spread

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Advanced Strategies for Options - Horizontal Spreads - Bullish Calendar Spread

For aggressive investors a bullish calendar spread may be more suitable. In a bullish calendar spread one sells the near term call and buys a longer term call but he does so when the underlying stock is well below the strike price of the calls. The advantage of doing this is both calls are very close in price thus the initial debit is extremely small.

This type of position can be very attractive because of the low dollar investment and large potential profit but two criteria must be fulfilled to generate maximum profits.

As with any spread the first criterion is that the sold or near month call expires worthless. There is a reasonably good chance this will occur because of the short time frame to expiration and the fact that the stock is initially well below the strike price. If the stock falls or rises only modestly the first criterion will be met.

The second criterion is a different kettle of fish. Unlike the neutral calendar spread when it is in the best interest of the investor to liquidate the long call position when short call position expires, the bullish calendar spread involves holding the long call position. The investor is essentially selling the near month call to offset the cost of the distance month call. If the stock rises substantially there is tremendous profit potential because should the first criterion be met the effective cost the long call position is small.

When using bullish calendar spreads investors should be careful to ensure the underlying security has sufficient volatility. As mentioned above for this strategy to really be effective the stock must rise substantially. It is also important that investors not use strike prices too far above the current underlying stock price. Once again the position only generates significant gains if the long call position gets into the money. It’s important to make this possibility realistic.

Megan believes in the seasonality of Internet stocks. For several years these issues have traded sideways to lower during the summer months only to rise substantially into the holiday season. With this in mind Megan decides to establish a bullish calendar spread for her favorite Internet retailer, Amazon.com (AMZN). With Amazon trading at 70 in May Megan sells one contract of the AMZN July 80 call for $12 and buys one contract of the AMZN December 80 call for $14 for a net debit of $2 per contract or $200.

If AMZN rises substantially prior to the expiration of the short calls (July) the spread will effectively be in- the- money and losses may occur. The deeper in- the- money the worse it is for Megan but her losses are limited to the net debit of $200.

For the purpose of the following example we will assume that the short call expires worthless thereby reducing Megan’s cost of the long call positions by $12 per contract.

AMZN Share Price at Expiration	July 80 call price	Profit for July 80 call calls	December 80 call price	Profit for December 80 calls	Total Profit
70	$0	$1,200	$0	($1,400)	($200)
75	$0	$1,200	$0	($1,400)	($200)
80	$0	$1,200	$0	($1,400)	($200)
85	$0	$1,200	$5	($900)	$300
90	$0	$1,200	$10	($400)	$800
95	$0	$1,200	$15	$100	$1,300
100	$0	$1,200	$20	$600	$1,800

As we can see Megan’s losses are limited to her initial debit of $200. After AMZN’s stock price moves beyond the $80 strike price the big profits begin. In fact, if AMZN rises to $100 by the December expiration Megan makes a profit of $1,800 on her modest $200 investment, a return of 900%.

Summary:

1. Bullish calendar spreads can yield huge profits if the near term call expires worthless and the underlying stock price rises substantially after the near month expiration.

2. Risk is limited to the net debit.

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