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Know Your Options

Even if you aren't that familiar with options, I'll bet you've heard someone use the term 'calendar spread'.

Whether they knew what they were talking about is another story.

So let's define it here.

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 by buying the nearby and selling the further out - but today, let's keep our focus on the long side.

Example

Let's use Green Mountain Coffee (GMCR - Analyst Report) for this example. And let's say it was trading at $83 when you put the trade on.

  • Let's say you wrote the October 2013, 95.00 call for 2.20 (collect $220)
  • And let's say you bought the January 2014, 95.00 call for 6.90 (paid $690)
  • net cost (debit) is 4.70 or $470

Why would I want to do this?

The maximum potential loss is limited to what you paid for the spread – in this case $470. (But that's only if you held onto the long-dated option after the expiration of the short-dated one. If you removed them together, your risk would always be less than that because the longer-dated one would always have at least some value to it (time value) even if it was way out-of-the-money.)

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 Green Mountain remained flat ($83) when the October options expired.

  • At expiration, the Oct. 95.00 call I wrote for $220 is now worth $0
  • And the Jan. 95.00 call I bought for $690 might now be worth $575
  • my calendar spread is worth $575
    $575 less my cost of $470 = profit of $105 or a 22% profit

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 always be limited to $470.

Now let's say GMCR rose to our strike of $95 by the expiration of the October call.

  • At expiration, the Oct. 95.00 call I wrote for $220 is now worth $0
  • And the Jan. 95.00 call I bought for $690 might now be worth $8.50
  • my calendar spread is worth $850
    $850 less my cost of $470 = profit of $380 or an 81% profit

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

This is a great strategy.

Granted, you're 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 20%, or 30%, or in this case an 81% return isn't small at all. If you put ten of these on for example, before commissions, that would cost $4,700. If you made $105 profit on each one, that's a $1,050 profit. And if you made $380 on each one, that's $3,800 on just a $4,700 investment in just under 2 months.

And that's pretty exciting.

You can learn more about different types of 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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