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Know Your Options

Here’s a great option strategy to use if you have a neutral (sideways) or mildly bullish outlook on a stock.

This one lets the investor benefit from time decay, which is usually the very thing that wreaks havoc on most investor’s options.

And it’s a limited risk way to make money when a stock is going sideways, which is something that you simply cannot do in the actual stock itself.

Definition

A Calendar Spread (also known as a ‘time spread’ or ‘horizontal spread’) is when you sell (write) an option in one month and buy an option with the same strike price but in a different, further out month.

Since the option you’re writing has less time (worth less) and the one you’re buying has more time (will be worth more), this can also be referred to as a debit spread as well.

You can do this with puts too – sell a put in a nearby month and buy the same strike in a further out month.

As you would expect, you’d have a neutral to bullish bias with the calls and a neutral to bearish bias with the put.

You can also ‘sell’ this strategy as well buy buying the nearby and selling the further out – but today, let’s keep out focus on the long side.

Example

Let’s use AMZN for this example:

  • Let’s say you wrote the Jan. 265 call for 3.50 (collect $350)
  • And let’s say you bought the Apr. 265 call for 13.00 (paid $1,300)
  • net cost (debit) is 9.50 or $950

Why would I want to do this?

The maximum potential loss is limited you what you paid for the spread – in this case $950.

The maximum profit if removed together would be the difference between the two option prices at the expiration of the nearby month.

Let’s say AMZN closed below $265 when the Jan. options expired.

  • At expiration, the Jan. 265 call I wrote for $350 is now worth $0 (gain of $350)
  • The Apr. 265 call I bought for $1,300 might now be worth $1,200 (loss of -$100)
  • my calendar spread is now worth $1,200

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  • $1,200 less my cost of $950 = profit of $250 or a 26% gain on money invested

If I wanted, I could decide to hold onto that further out call if I thought a rally was underway – and make even more money.

But of course, if it went down, I could lose the rest of the premium. But again, my maximum loss would be limited to the price paid for the spread.

This is a great strategy, especially if you did this with out-of the-money options and the stock climbed up to the strike price by the expiration of the nearby option month. In this case, you’d make even more money because the short call would expire worthless (meaning you’d keep the entire premium as in the example above), but the long call, which is now at-the-money, would have likely increased in value, giving you an even bigger gain as both options would have been profitable.

Granted, you’re still limited in your profit potential, but you’re capitalizing on the dynamics that the nearby month will lose its value (time value) quicker than the further out one.

Some people probably don’t bother with this strategy because the profit potential seems small. But if you look at it in percentages, a 10%, or 20%, or in this case a 26% return isn’t small at all for one trade. And if you put five of these on for example, before commissions, that would cost $4,750. If you made $250 profit on each one, that’s a $1,250 profit.

And that’s pretty exciting.

You can learn more about different option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here.

And be sure to check out our Zacks Options Trader.

Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.

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