Investors who want to participate in this market can use options to limit their risk to an adverse move. Today we investigate the simple Calendar Call Option Strategy of buying and selling calls of the same strike price but different expiration months, to participate in profits when the underlying stock price trades sideways or modestly rises or falls.
The S&P/ASX 200 has had a fantastic couple of weeks since it bounced sharply off its 200-day moving average. Markets have a cyclical tendency to drift higher into the end of the year and if you want to participate in this move the Calendar Call Option Strategy is a defined risk way to trade. The index is now searching for support around the key medium-term pivot level of 4500 and this level has provided support in previous months.
There are a number of reasons why a long term investor may not want to jump into an outright stock position in this market environment, such as the risk of a pullback near-term and being exposed to stock price movements ahead of the resolution of the US “fiscal cliff”.
Calendar Call Option Strategy
The Calendar Call Spread is a cheaper alternative to buying the stock outright and is a neutral-to-modestly bullish options strategy, that profits when the underlying stock trades sideways or trades within a tight price range. By using this option strategy, you can limit the cost of the exposure to a stock, while also limiting the risk in holding this position. The downside is a limited exposure to a sharp up-move.
In a Calendar Call Spread the trader buys and writes Call options simultaneously, at the same strike price, but with different expiration months. This is classified as a Horizontal Call Spread.
A Calendar Call Spread profits primarily from the difference in rate of time decay in the option premium, between the near-term short options and the longer-term option. This is possible as near-term option premiums decay faster than longer-term option premiums.
You should use a Calendar Call Spread when you want to profit from an underlying asset that is expected to trade sideways or trade within a tight price range, and want to take a bullish position on the stock in the longer term.
The Calendar Call Option Strategy is very flexible and provides a limited risk exposure to the underlying stock. The strategy allows you to profit from an underlying stock price which is rising and/or falling modestly or trading sideways, gaining a leveraged bullish position if the short option expires worthless.
For the trader, the maximum risk is limited to the initial premium paid for the call option, while the maximum profit is also limited.
Profit Potential of Calendar Call Spread
The Calendar Call Option Strategy spread reaches its maximum profit when the underlying stock closes just below the strike price of the short call options at expiration of the short call options.
The value of a Calendar Call Option Strategy during the course of the trade, and prior to the expiration of the short call options, can only be arrived at using an options pricing model such as the Black-Scholes Model, which can determine the expiration value of the longer-term call options.
Equally, the breakeven point of a Calendar Call Spread is the point below which the position will start to lose money if the underlying stock rises or falls strongly and can only be calculated using an options pricing model.
In summary the keys to the risk/reward of Calendar Call Spread at expiry are:
* the upside maximum profit is limited
* the maximum loss is limited to the net debit paid
Time Decay
Time decay is the enemy of most options traders, particularly those who are long options. Some traders visualise the impact of time decay like PACMAN, because it continuously eats away at the value of the option, particularly if the underlying stock trades sideways. This is where the Calendar Call Spread excels, because time decay is working for you.
Advantages & Disadvantages of a Calendar Call Spread
The primary advantage of a Calendar Call Spread is that it makes the mathematics of option trading work for you, because the Calendar Call Spread profits primarily from the difference in rate of premium time decay between the near-term short options and the longer-term option. This is possible as near-term option premiums decay faster than longer-term option premiums and this is most profound in the last few weeks of an option’s life.
This strategy will profit if the underlying stock trades sideways, or drifts higher and/or lower before the short option expiry.
If the trade acts according to the initial trade plan, then the short option position expires worthless and you are then exposed to bullish movements in the underlying asset, which can be controlled at a discount for the longer term.
There are disadvantages in using this type of spread, because profits will be limited, even if the underlying asset rises strongly. Losses can also be sustained if the short call options are assigned when the underlying asset rallies, but this risk can be eliminated by using European options which can only be exercised at expiry.
Additionally you do have the option to adjust your position during the time of the trade, by either closing out of the short options position, if you consider that either the underlying stock prices is due for a bounce or you expect a strong rally to continue, or simply closing out the position.
Recent Trade – National Bank (NAB)
A recent trade taken by our clients was to buy a NAB Calendar Call Spread, two weeks prior to the November options expiry.
National Australia Bank (NAB) shares had suffered a 15% slide since its recent peak when it was trading at over $27.00. The share price had fallen to around $23.00 and was trying to establish support around this level. The $22.50 support level has held for the past 18 months and this was a trade for a bounce from these levels. While the chart looked oversold there was a chance NAB would just trade sideways around the $23.50 level, so the trade was entered to profit from a sideways and bullish move on NAB while helping to reduce the risk.
To profit from this view we opened a NAB Calendar Call Spread. The objective of this trade is for NAB to ideally be below the sold call strike at expiry. So instead of trying to profit from a sharp bounce from NAB, we were looking to profit from a steady recovery of NAB near-term. To put it more simply, we felt NAB would hold around $23.51 before November options expiry (29 Nov’12), and trade higher from then on.
The maximum possible profit on this trade would be achieved if NAB held just below the short strike $23.51 level at November options expiry. The maximum risk on the trade was the initial debit; this would occur if NAB is above $23.51 at November options expiry (or significantly below that level).
CHART 1: National Bank (NAB) Calendar Call Spread
Trade Details
In this trade we entered the position when NAB was trading around $23.84, two weeks prior to expiry. The trade was established by Buying to Open NAB 2350 DEC12 Call for 58c and simultaneously Selling to Open the NAB 2351 DEC12 Call for 36c. The total cost was limited to the initial 23 cents premium paid.
Payoff Diagram at Expiry
CHART 2: Payoff Diagram at Expiry for the NAB Calendar 2351 NOV12/DEC12 CALL Spread
Note if your view changed during the trade, you could have bought back the short call or closed the trade prior to expiry.
Risks and Profit Potential
The Calender Call Spread profits when the stock price trades sideways or finishes below the short strike price. The maximum risk is limited to the initial premium paid for the option spread. The maximum profit is also limited.
In summary the Calendar Call Spread strategy offers limited upside profit, while the maximum risk is limited to the Net Debit Paid. These risk/rewards are shown in the Payoff diagram above.
Note the Calendar Call strategy can be used in order to gain an exposure to National Bank, while limiting the outlay and risk to the premium paid.
Result
NAB shares traded sideways up to expiry and we were of the view that they were likely to push higher for the end-of-month portfolio rebalancing.
We were able to buy back the SHORT NAB 2351 DEC12 Call for 29c on the day before expiry. We held the LONG NAB 2350 DEC12 Calls until the day after expiry and were able to sell them for 92c, for an overall total CREDIT of 41c (a profit of around 180%, for a two week trade). Note transaction costs have not been included in these calculations.
The Trade
Options can be used in order to gain leveraged exposure with limited risk, while still participating in potential profits in the underlying stock. The Calendar Call strategy can allow you to participate if a stock is trading sideways or modestly up or down, while limiting your loss to the premium paid.
** Please note your may need to refer to a tax professional regarding eligibility of franking credits.
Bonus
There is another trade setting up right now that you could potentially profit from before Christmas. If you would like more information please call 1300 610 024 or email advisory@d2mx.com.au.
For trade ideas and recommendations on how to trade in this market, sign up for a free trial of the D2MX Daily Trading Report, which provides a daily serving of insightful market analysis from the D2MX Advisory team, including:
• Trade ideas and strategies
• Dividend enhancement strategies
• Market scans to watch
• International market analysis, and
• Highlights from the S&P/ASX 200
To request an obligation-free trial, call 1300 610 024 or email advisory@d2mx.com.au.
Michael Hevern
Investment Adviser – D2MX Trading
See Also:
Options Trading for All Types of Market Environments (Part 1): The Protective Put
Options Trading for All Types of Market Environments (Part 2): The Covered Call
Options Trading for All Types of Market Environments (Part 3): The Covered Call Collar
Options Trading for All Types of Market Environments (Part 4): The Stock Repair Strategy
Options Trading for All Types of Market Environments (Part 5): Limited Risk Short Selling Strategy
Options Trading for All Types of Market Environments (Part 7): Dividend Capture Covered Call Collar
Options Trading for All Types of Market Environments (Part 8): Hedging With a Bear Put Spread
Options Trading for All Types of Market Environments (Part 9): The Bull Call Strategy
Options Trading for All Types of Market Environments (Part 10): Dividend Capture Covered Call Collar
This report was prepared by Michael Hevern. It represents the views and opinions of the author. It is not intended for use by any third party, without the approval of Michael Hevern. While this report is based on information from sources which are considered reliable, its accuracy and completeness cannot be guaranteed. Any opinions expressed reflect my judgment at this date and are subject to change. Contracting Hevern Pty Ltd is a Corporate Authorised Representative No. 408868 of D2MX Pty Limited ABN 98 113 959 596, AFSL No. 297950 (D2MX), and Michael Hevern has been appointed as an Authorised Representative of Contracting Hevern Pty Ltd. Opinions, conclusions and other information expressed in this report are not given or endorsed by D2MX, unless otherwise indicated. The information contained in this Report is General Advice only, as the information or advice given does not take into account your particular objectives, financial situation or needs.
Disclaimer: Using leverage to invest can be a two edged sword, as it can magnify your returns when the stock price rises, but will in turn magnify the losses if the trade does not perform as expected.
