In the last article we looked at a bullish option trade. This time we’ll take a look at what’s known as a Calendar or Time Spread. The mechanics of the trade are simple, just identify a share that is currently trading sideways and is expected to stay within a range. Simply buy a long term option, whilst at the same time selling a shorter term option at the same strike price to help pay for the long term option. The main object of this strategy is to bring in monthly income and ultimately “pay off” the longer term option, which can then be sold at a profit.
A Calendar Spread can use either Calls or Puts and is short-term neutral, but is generally longer-term bullish or bearish. In the event the short option expires worthless, the trader can sell another near term option with the same strike price to create a second calendar trade if their outlook is still neutral. Finally, the trader can choose not to sell another option in the short term and simply remain long the option they own if the share is moving quickly in a favourable direction.
Calendar spreads are limited risk trades, but can have unlimited reward potential to the upside for the call calendar and limited, but high potential reward to the downside for the put calendar, depending on adjustments. Now, in the event the underlying share makes an adverse move, the short option could be assigned, but the trader can then exercise their long option to sell those shares again at the same price.
As you can see from the ProfitSource chart, Telstra (TLS) has been trading in an Elliott Wave sideways pattern since March 08. I’m slightly bullish on (TLS), longer term.
click to enlarge
So, let’s see what the trade looks like. I’m going to use slightly ITM Put options, instead of OTM Call options. Yes, you can do that and we’ll actually get into the trade for a smaller debit than using Call options. Also, trading the Call options could put me at risk if a dividend is paid while I’m holding the “short calls”. I’m looking for TLS to rise and allow me to keep the premium I get for the September Put options.
The trade is, buy one November 08 Put option contract with a strike price of $4.56, while at the same time selling one September 08, $4.56 strike, Put option contract. This trade is submitted as one order for a debit of 8cents. This trade now has a maximum risk of $83 per contract (8 cents x 1040 shares). In this instance TLS has 1040 shares per contract.
Note, not all contracts contain 1000 shares.
Chart 2 - OptionGear Risk Graph of the TLS Calendar Trade
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The main risk that I face in this trade is if TLS continues to fall and my short September Puts are exercised and I’m assigned the shares. Still no big problem, if my account is large enough, I may choose to hang onto the shares and wait for TLS to rise. Remember I still own the November Puts and can sell the shares at $4.56 anytime I want, up to the November expiry date. Maximum risk will still be $83 per contract.
Remember, you always have options.