Calendar Spreads Tutorial
On a calendar spread, the goal is for the share price to move higher but not higher (or lower of you are doing puts) than the strike price of the later expiration. That allows the earlier expiration to expire worthless.
Our rationale –
to make money from the difference in delta (change over time as derived from the strike price) and theta (time value decay)
to allow the short option (the one we sold) to expire worthless and leaving us with the long option at a much-reduced cost.
We can then sell another option against our long option to reduce our cost further or hold it straight long
to reduce the cost of the total trade thereby managing our cash prudently while enjoying a good and possibly great upside.
To execute a calendar spread, you must buy a call and sell a call option against it or buy a put and sell a put option against it – that is for ALL spreads.
So, when do I use a calendar spread?
For Short term trades, I use it for earnings.
For long term trades, I use it for positioning stocks that are usually expensive but ones I think can really move over time.
Here is an example. I will use BA:
I think BA will eclipse the $200 level over the next couple of years but if I were to buy BA it would cost me $146 per share. For 1000 shares, that would cost me $146,000 – no thanks.
I could buy BA at the money LEAPS that expire in Jan 2024 LEAP calls for $33 but that would set me back $33,000 – no thanks again.
Since I think BA is going much higher, I would engage a 2025/2024 calendar spread using a higher strike price. The rationale here is that I have 2 years for the play to work out but i really don’t want it to work out until year 2
I would buy the Jan 2025 $200 calls and against them I would sell the Jan 2024 $200 calls.
The 2025 calls are $24 and the 2024 calls are $14. So If I buy the Jan 2025 and sell the Jan 2024 ($200 strike) my cost is now $14 +/- or $10000 – less than 10% of what I would spend on the stock.
If BA were to head higher the 2025 long calls would gain more than the 2024 short calls since they have much more time left
If BA stayed where it is, the 2024 calls would expire worthless and I would still have a year left on the 2025 calls and my cost would be $14.
Now, I have the opportunity to sell more calls going into 2025 at a higher strike to reduce my cost further and increase my upside.
Let’s say BA moves higher, over $200 in 2023.
I would still make money as the time value and expectation of the later expiring 2025 calls would pick up more value. I could buy back the 2024 calls and re-sell higher strike 2025 calls to convert to a vertical spread at any time. It is nearly impossible for the 2024 calls to exceed the value of the 2025 calls
The downside is that BA does not go anywhere for the next two years and I would lose a chunk of premium
What if BA crashed (forgive the pun)?
Well, then if I had a 25% stop-loss on the stock, I would lose $36,500. The most I can lose with the LEAP calendar spread is what I had invested – around $10,000. But, I have two years for the play to work, in case BA gets stopped out early.
On a short-term play – like TSLA for example. I can buy a call expiring in two weeks and sell the calls that expire at earnings to lower my cost. Those shorter-term options will lose all premium (except for intrinsic value) at earnings.
If my strike is higher than where the shares are at earnings, but not much higher, I get to keep them for another week – the key is that I will have reduced my cost substantially and thereby also reduced my dollars at risk.