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Before we jump into this issue of TradeSmith Daily, I wanted to share a quick recap of what we sent throughout the week not only for anyone who may have missed something, but for anyone who wants to go back and easily reference the stories we recently published.
There are always opportunities to make money in any market condition — so long as you know where to look — and we’re here to guide you in finding those opportunities.
- On Monday, we discussed how you can turn the Federal Reserve’s rate hike into a profit opportunity.
- On Tuesday, we talked about how investors and traders can adopt the same mentality as seven-time Super Bowl winner Tom Brady in his relentless pursuit of perfection.
- On Wednesday, we reviewed how to be proactive in this type of market and how to invest and trade on your terms.
- On Thursday, Senior Analyst Mike Burnick determined that the 60/40 rule for investing in stocks and bonds is over… and showed you where to invest your money now.
- And today, we’re going to talk about using calendar spreads. I love options because of the flexibility they provide in making money.
Or how about betting that Apple Inc. (AAPL) stays above $100 and getting paid when that bet pans out?
That’s why I was super excited when I first learned about how to use calendar spreads.
These unique spreads take advantage of the differences in time decay.
You see, options lose their value at an accelerating rate, as shown in the graph below.
The blue line represents the extrinsic value of an option, the part that decays over time.
As the option approaches expiration, that rate of decay increases.
Calendar spreads take advantage of this curve in some pretty unique ways.
Plus, you can combine them with vertical spreads to create some fascinating setups.
To start, let’s construct a basic calendar spread.
Calendar Spreads 101Like every other option spread, calendar spreads buy and sell options on the same underlying asset.
However, instead of picking different strike prices, I choose different expirations.
A typical put credit spread on AAPL could work as follows:
- I sell the $100 put that expires in one month for $2.00.
- I buy the $99 put that expires in one month for $1.75.
- The net credit I receive is $2.00 – $1.75 = $0.25.
- $0.25 is the maximum potential profit I can achieve if AAPL closes at or above $100 by expiration.
- My maximum potential loss is the difference between the strike prices minus the credit I received, or $100 – $99 – $0.25 = $0.75.
- Maximum loss occurs if AAPL closes at or below $99 by expiration.
- I sell the $100 put that expires in one month for $2.00. Let’s label this option A.
- I buy the $100 put that expires in two months for $3.00. Let’s label this option B.
- This trade costs me $3.00 – $2.00 = $1.00, which is also my maximum potential loss.
I’ll walk you through some scenarios to help you understand.
Let’s say I initiate this trade and pay the $1.00. One month later the stock is still at the same price as when I put on the trade; everything else, including implied volatility, is the same.
That means option A, which I sold for $2.00, expires worthless. However, the option I bought, option B, still has one month until expiration and theoretically should have a price of $2.00, like option A did at the start. (It has the same strike price as option A and now has the same time until expiration as option A did.)
I can then sell option B for $2.00 and turn a profit of $1.00 since I paid $1.00 to initiate the trade.
Now, what happens if AAPL starts to trade higher, say to $105 at the end of the first month?
Well, the $2.00 option A still expires worthless. However, the $3.00 option B is going to be worth less than $2.00 since AAPL has traded away from the $100 strike price, and as we know, a put option’s value declines the higher a stock goes.
But I can’t say for certain what price it would be without knowing other pieces of information, such as the delta and gamma of the different strike prices.
Conversely, if AAPL dropped to $95, option A would now be worth $5.00 since it’s $5 in the money and made up entirely of intrinsic value.
Option B would also be in the money for $5.00. Plus, it would have a little bit of extrinsic (time decay) value. So option B might be worth $5.25.
In that case, I would still lose $0.75 since I paid $1.00 to put on the trade and would only gain $0.25 from the difference between options A and B at expiration.
This might seem like a raw deal, since you need the stock to stay at the same price to turn a profit.
But now I want to show you how to tweak this a bit and create a more dynamic trade.
A Vertical Calendar SpreadTechnically this is still called a calendar spread, but let’s go with the term “vertical calendar spread” for now.
And let’s use Block Inc. (SQ) as an example.
I want to bet that SQ will go higher, but I also know that because implied volatility is high, call options are extremely expensive.
Here’s a way to create a unique trade using a calendar and vertical spread.
Assume that SQ is trading at $84.50.
- I sell the $120 call that expires in 38 days for $1.43. Let’s call this option A.
- I buy the $120 call that expires in 129 days for $6.10. Let’s call this option B.
- My net cost is $6.10 – $1.43 = $4.67
- As long as SQ stays below $120, option A expires worthless.
- Option B will lose value over that 38 days, but at a slower rate than option A.
- Increases in implied volatility will increase the price of option A.
- If the price of SQ increases, that will also increase the value of option A.
- In the best-case scenario, SQ lands right at $120 after 38 days and implied volatility increases. That means I get to keep the $1.43 I got for selling option A, and option B is probably worth a whole lot more than $6.10 (likely more than $12, using back-of–the-envelope math).
Now, there are dozens of ways to construct these types of trades.
So, let me give you three things to keep in mind:
- Higher implied volatility = higher option prices.
- Extrinsic (time decay) value is highest when the stock’s current price matches the strike price.
- Time decay speeds up as you approach expiration.
Now let me ask you, have you ever used a calendar spread before? If no, what companies would you like to try this strategy out on? If yes, what do you look for when creating your calendar spread?
Everyone has a different trading style, so I’m curious to hear more about how you evaluate opportunities.
Email me your thoughts.