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Calendar Call Spread - Introduction
The Calendar Call Spread, being one of the three popular forms of Calendar Spreads (the other 2 being the Calendar Put Spread and the Ratio Calendar Spread), is a neutral / bullish strategy that profits in pretty much the same way a Covered Call does;
When the stock stays stagnant or goes up slightly.
The Calendar Call Spread is really a leveraged Covered Call that replaces the underlying stock with its LEAPS so that more
short positions can be written. A Calendar Call Spread profits primarily from the difference in rate of premium decay between the near term short options and the long term LEAPs.
This is possible as near term option premiums decay faster than long term option premiums.
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Because the Calendar Call Spread buys LEAPs which are more expensive than the short term options sold, this strategy results in a net debit and is therefore a form of Debit Spread.
There are 2 ways to establish a Calendar Call Spread. One way is to buy and write options of different expiration months and different strike prices. In this case, it is classified as a Diagonal Spread or Time Spread.
The other way is to buy and write options of different expiration months but at the same strike price. In this case, it is classified as a Horizontal Spread. We will be exploring both versions of
the Calendar Call Spread here. I call them the Diagonal Calendar Call Spread and the Horizontal Calendar Call Spread.
(These classifications are only for a deeper understanding of the kinds of option spread strategies and is not necessary for the execution of these strategies.)
When To Use Calendar Call Spread?
One should use a Calendar Call Spread when one wishes to profit from an underlying asset that is expected to stay stagnant or with slight bullish inclination.
How To Use Calendar Call Spread?
Diagonal Calendar Call Spread
In this version of the Calendar Call Spread, all you have to do is to purchase an In the Money (ITM) LEAP and then sell At the Money (ATM) or Out of the Money (OTM) near term calls against the LEAP.
Example : Assuming QQQQ trading at $45 now. Buy To Open 10 contracts of QQQQ Jan 2008 $44 Call options at $5.70.
Sell To Open 10 contracts of QQQQ Jan 2007 $45 Call at $0.75.
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We use In The Money (ITM) LEAPs instead of At The Money (ATM) or Out of The Money (OTM) ones so that the Delta value (read about what Option Delta and other option greeks are.)
of the LEAPs are higher than the Delta value of the short term options. This is to ensure that the LEAPs rise in value faster than the short term calls should the underlying asset stage a rally.
Horizontal Calendar Call Spread
In this version of the Calendar Call Spread, you will purchase At The Money (ATM) LEAP call options and then sell ATM near term calls against the LEAP call options.
Example : Assuming QQQQ trading at $45 now. Buy To Open 10 contracts of QQQQ Jan 2008 $45 Call options at $4.70.
Sell To Open 10 contracts of QQQQ Jan 2007 $45 Call at $0.75.
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The ATM LEAP options in this case are cheaper than the ITM LEAP options in the Diagonal Calendar Call Spread and therefore allows you to put on more positions and also
attain a higher % profit than the Diagonal Calendar Call Spread. The drawback is that you are taking more risk should the underlying asset
stage a rally. In this case, as the near time short call options have a higher delta value than the ATM LEAP call options, you will lose money on the
short term call options faster than you will make money on the gain in the LEAP call options. This makes it more dangerous than a diagonal Calendar Call Spread
and should only be applied on underlying assets that are confident of staying stagnant or very near stagnant.
Profit Potential of Calendar Call Spread :
Diagonal Calendar Call Spread
When the underlying asset
closes at or slightly lower than the strike price of the short call options, the short call options
expires out of the money so you make the full value of the short call options in profits. When the underlying asset is higher than the strike price
of the short call options upon expiration, the LEAP call options increase in price faster than the short call options due to a higher delta value, thus resulting in a net profit.
The Diagonal Calendar Call Spread's maximum profit occurs when the underlying asset closes exactly at the strike price of the short call options upon expiration of the short call options.
From the above example : Assuming QQQQ close at $45 on the third Friday (option expiration day) of Jan 2007.
You will make the $750 value of the 10 Jan 2007 $45 Call options that you wrote as they expire out of the money, less,
the decay of the 10 contracts of Jan 2008 $44 Call options.
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Horizontal Calendar Call Spread
A Horizontal Calendar Call Spread profits when the underlying asset closes at or slightly above the strike price of the short call options. The difference between
this and the Diagonal Calendar Call Spread above is that the latter is able to profit even when the underlying asset moves much higher than the
strike price of the short call options as the long call options has a greater delta value than the short call options. Unlike the Diagonal Calendar Call Spread, should the
underlying asset stage a rally, a Horizontal Calendar Put Spread would result in a loss.
Similar to the Diagonal Calendar Call Spread, the Horizontal
Calendar Call Spread's maximum profit occurs when the underlying asset closes exactly at the strike price of the short call options upon expiration of the short call options.
From the above example : Assuming QQQQ close at $45 on the third Friday (option expiration day) of Jan 2007.
You will make the $750 value of the 10 Jan 2007 $45 Call options that you wrote as they expire out of the money, less,
the decay of the 10 contracts of Jan 2008 $45 Call options.
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Profit Calculation of Calendar Call Spread:
Diagonal Calendar Call Spread
Profit = Long Call Value at expiration of short term call options - Net Debit
From the above example : Assuming QQQQ close at $45 as mentioned above
and QQQQ Jan 2008 $44 Call Options are trading at $5.60 then.
Profit = $5600 - $4950 = $650
Profit % = $650 / $4950 = 13.13%
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Horizontal Calendar Call Spread
Profit = Long Call Value at expiration of short term call options - Net Debit
From the above example : Assuming QQQQ close at $45 as mentioned above
and QQQQ Jan 2008 $45 Call Options are trading at $4.60 then.
Profit = $4600 - $3850 = $750
Profit % = $750 / $3850 = 19.48%
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As we can see from the above, the Horizontal Calendar Call Spread yields a higher profit with a higher risk of loss and the Diagonal Calendar
Call Spread yields a lower profit with a lower risk of loss. Such is the way option trading works, profits are always proportionate to
the risk of loss.
Risk / Reward of Calendar Call Spread:
Upside Maximum Profit: Limited
Maximum Loss: Limited
(limited to net debit paid)
Break Even Point of Calendar Call Spread:
The breakeven point of a Calendar Call Spread is the point below which the position will start to lose money if the underlying asset falls.
Break Even = Stock Price when long call value is equal to net debit
The long call value at different prices can only be calculated using the Black-Scholes model.
Advantages Of Calendar Call Spread:
Able to profit even if underlying asset stays stagnant.
Able to offset losses if underlying asset drops in value.
Buying the LEAP in lieu of the stock can generally allow the underlying asset to be controlled at a discount.
Losses are limited to the net debit.
Disadvantages Of Calendar Call Spread:
Profits are limited even if the underlying asset rallies.
Losses can be sustained if the short call options are assigned when the underlying asset rallies.
Alternate Actions for Calendar Call Spreads Before Expiration :
1. If you wish to profit from a rally in the underlying asset, you could buy back
the short call options before it expires and allow the LEAP Call Options to continue its profit run.
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