Last week I wrote about using the Bull Call Spread in a way that was not exactly bullish, so that it became a price-neutral trade based on time decay. This week we’ll look at doing the opposite: changing a neutral spread into a directional one.
The Calendar spread is most often thought of as a way to profit, with a price-neutral trade, from the difference in the rate of time decay between a short-term option and a longer-term option. To use it in this way, we buy an option with several months until expiration; then sell a shorter-term option with the same type (call or put) and the same strike price, but with a nearer expiration date. For example, on June 27, with SPY at around $161, we could have bought the SPY September 161 calls at $5.04, and sold the SPY July 161 calls at $2.57, for a net debit of $2.47. The profit graph of this trade is shown below.
This chart shows the amount of profit or loss this trade will make on July 19, the expiration date of the July calls, at any given price of the SPY at that time. Notice that this position is most profitable if the price of SPY is right at the $161 strike price on July 19. At that exact price, it would make about $1.71 per share on our $2.47 investment, or about 69%, in 22 days.
It’s not likely that SPY would end up at exactly $161, but that is not required in order to make some profit. All we need is for SPY to be pretty close to that value. The vertical lines at $157.12 and at 165.21 are set where the green profit curve crosses the $0 P/L line. If SPY were anywhere within that price range on July 19, the trade would make a profit. If we felt that SPY would stay within that 8-point range for the next 3 weeks, it would be an OK trade.
This would be a neutral trade from the standpoint of the SPY price. With the strike price right near the current price, we don’t care which way SPY goes, as long as it doesn’t go very far.
In this neutral style of calendar trade, both options will be losing value every day to time decay. But the July options, being much closer to expiration, decay faster. That difference in time decay rates is the main source of profit. Increasing implied volatility will also improve its performance, since we are net long time value.
We’d plan to terminate this position on the expiration of the July options on July 19. At that time the September long calls will still have two months to run. Looking at the situation as of July:
The July options will have lost all of their time value, while the Septembers will have lost much less of theirs. If SPY is below $161, the July options will expire worthless, and the position will be worth whatever the September calls are worth then. According to the option pricing model, the Septembers would be worth $4.42 with SPY at $161. That is $1.71 more than our original debit of $2.57. If SPY were below $161, our Septembers would be worth less. At a SPY price of $157.12, they would be worth $2.57 (the amount of our original cost for the position), and we would break even. (We have to have a diagramming tool to see this break-even point. It can’t be calculated in a simple way because it depends on the time value in the September calls at a future date). At any SPY price below this break-even point, our September calls will be worth less than $2.57, and we would have a loss. In the worst case, if SPY were to drop below about $133, our September calls would be so far out of the money that they would be worthless, and we would lose our entire $2.57 debit.
What if the July options are not worthless on their expiration date? If SPY is above $161 on July 19, both options will be in the money. Both will have the same amount of intrinsic value, which will be the amount by which they are in the money. The short July options will be worth only whatever this intrinsic value is, since they will have no time left. The long Septembers will also have that same intrinsic value; but in addition they will have time value, with two months left in their life. Since the intrinsic value of the Julys and the Septembers will offset each other exactly; and the Julys will have no time value at all; above $161 the value of the spread will be equal to the time value in the Septembers at that time. That time value would be greatest at exactly $161. It would be less and less at higher SPY prices. At a SPY price of $165.21, the time value in the Septembers would be $2.57 (our original cost), and we would break even. At higher SPY prices the time value of the Septembers would be less than $2.57 and we would have a loss. At very high prices, beyond about $197, the Septembers would have no time value (there being no chance of their finishing in September out of the money), and the spread would be worthless, losing our entire $2.57 debit.
All of the above assumes no change in implied volatility between now and July 19. If implied volatility rises, the time value in both options will increase; but the Septembers will increase more, since they have more time value to start with. Since we are net long time value, increasing volatility would improve the P/L for this position.
That’s how a neutral calendar works. So how could this be made into a directional (bullish or bearish) position? That’s easy. Note from the diagram above that the peak in the P/L curve occurs at the 161 strike price. If we choose a different strike price, the P/L peak will be at that price. If we are bullish, we could just choose a higher strike price. Suppose we believe that SPY could go as high as 168 by July 19. We could use that strike for our calendar, placing the P/L peak at that price.
Below is the diagram for a July/September call calendar at the 168 strike, which we could have entered for a net debit of $1.53:
Note that the profit peak is at the 168 strike, about $7.00 above the current price. At $168, the max profit on this spread would be $2.27 on our $1.53 investment, if it occurred on July 19; and somewhat less if it happened right away ($.95 if it happened today). By choosing a different strike, we have turned this into a bullish trade. We would have to be sure to close this position as soon as SPY hit $168, because profit declines above that.
The bullish calendar is an alternative that works well when we are bullish and volatility is expected to rise. It is well worth examining in these conditions, as an alternative to a vertical spread. Like the vertical spread, it gives substantial positive delta (profit from rising underlying price) at a low price, and reduces time decay substantially, compared to purchasing calls alone. Depending on the specific conditions, the Calendar may well be the best choice in a given situation.
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