Part III (Part I and Part II)

Final Stock Price Major Factor

As with most other option spreads it's often wise to exit the position prior to expiration because some risks increase as time passes.  If an investor makes the decision to hold the position until the near-term option expires, the settlement price of the underlying stock, or index, plays a vital role in determining the profitability of the calendar spread.  [I don't mean to imply that it's not important when the position is closed early.]

The following table shows the value of the IBM Jan/Dec 100 call spread (our example from Part I) when the position is closed at the end of the day on expiration Friday.  Volatility is assumed to be 45 (as good a guess as any):

NOTE: When IBM is 100 or less, the December 100 call expires worthless and the value of the Jan 100 call is the value of the calendar spread.

When IBM is higher than 100, the December call is in the money.  For the values in the table, the assumption is made that the IBM Dec 100 call is bought at parity (the option's intrinsic value, or the amount by which it's in the money) and the IBM Jan 100 call is sold at it's value.

 IBM Price 88 92 96 100 104 108 112 Dec 100 \$0.00 \$0.00 \$0.00 \$0.00 \$4.00 \$8.00 \$12.00 Jan 100 \$0.97 \$1.87 \$3.23 \$5.08 \$7.50 \$10.36 \$13.57 Spread \$0.97 \$1.87 \$3.23 \$5.08 \$3.50 \$2.36 \$1.57

As you can see from the data in the bottom row, the value of the spread is highest when the stock is near the strike price and steadily decreases as the stock moves away from the strike.

Thus, when trading calendar spreads, it's advantageous to have an idea where the stock price is headed.  For me and my comfort zone, I prefer to avoid predicting direction.

Bullish, bearish, or neutral?

If you are bullish on a stock, one way to play that feeling is to buy an OTM call calendar spread.  If you are correct, as the stock moves higher (towards the strike price of the spread), you not only gain as time passes, but you gain as the stock rises.  Of course, if it rises too far, the spread begins to lose value.  Thus, one reason to consider taking your profits early occurs if the stock moves to the strike.

The problem with have a neutral opinion on the stock is that the calendar costs the maximum when the stock is near the strike. That makes it costly to buy a calendar spread.  If you are truly neutral, buying an iron condor is probably a better choice.

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### 2 Responses to Calendar Spreads. Part III

1. semuren 10/09/2008 at 4:46 AM #

Greetings Mark:
Thanks for the great site. I really appreciate your work in options education.
So, I have a question based on your descriptions of calendar spreads in the three part series. Given the fact that IV usually goes up as the underlying goes down does it really make sense to buy bullish calendar spreads where the underlying need to move up to get into the highest profit zone for the spread? I would think that one would be better off using only bearish or neutral calendars and if one is slightly bullish and wants a lower probability higher reward bullish spread that a butterfly, given that it is short vol, would be more appropriate.
Thanks,
Semuren

2. Mark 10/09/2008 at 8:49 AM #

Thank you Semuren,
First, my preferences: I’m not a fan of calendar spreads and never use them – except when I choose double diagonal spreads. Such spreads combine calendars with iron condors.
Second, calendar spreads are very popular among individual investors. Thus, I though an educational series on them would be appropriate.
Your comment: When buying an OTM bullish call calendar spread, it’s true that the rising stock price will generally be accompanied by a lower implied volatility – and that reduces potential profits.
But, these spreads can sometimes be purchased for very low prices – allowing a bullish play for a very low cost – and thus, very low risk. I’m willing to accept reduced profits when risk is much lower.
I agree that bearish put calendars are better because of an anticipated increase in IV.
The problem with butterflies, is that real profits don’t accumulate until expiration approaches. True, you can unload the butterfly when the stock rises to the strike, but I never found that method to be sufficiently profitable and have very limited experience using butterflies, despite the fact that I’ve been trading options for 33 years.
I don’t disagree with your thoughts. But for my comfort zone, I don’t use either strategy.