Call Calendar Spreads In This Uncertain Market

Deciding whether or not to open a covered call position in this type of market condition can be a challenge for some traders and investors because the current market has been extremely choppy over the last two weeks. In this uncertain market, buying stock can be a much riskier investment because of these huge price swings. Another way to possibly go is a calendar spread. It can give a trader and investor a lot of the same benefits of a covered call, without the sometimes huge initial outlay of buying shares of stock as well as limited risk.

Buying a call calendar spread traditionally involves selling a near month call option and buying a same strike call option in a more distant month. Just like with a covered call, the short call in the calendar spread provides a source of profit. The purpose of the long call component of the spread is to provide protection for the short call. When this trade is established, it results in a debit because the long call will be more expensive than the short call due to the greater amount of time to expiration. The maximum risk on the trade is limited to the initial debit. The maximum profit occurs when the stock approaches or hits the strike price as the short call expires.

One of the greatest benefits of calendar spreads is that they can be entered with any directional outlook. An out-of-the-money (OTM) calendar spread can profit from bullish (with call options) or bearish (put options) stock moves and ATM calendar spreads can profit from a neutral stock outlook.

Example

Imagine International Business Machines Corp. (IBM) is trading at around $171. A trader thinks the stock will rise some but may be extremely choppy do to the uncertain markets. The trader decides $175 is a reasonable target within the next 30 days (a timeframe which coincides with September expiration). Thus, the trade sells the September 175 call. For protection, the trader buys the October 175 calls to complete the Calendar Spread.

Selling the September 175 call brings in a premium of 3.35 and buying the October 175 call costs 5.80. The total cost of the trade is $2.45. That represents the maximum risk for the trade, which would be suffered if a big move away from the 175 strike occurs.

Maximum profit is achieved if IBM trades at $175 at September expiration. The short Sep. 175 call will expire and the long Oct. 175 call will still have a month worth of time and be ATM. The exact amount cannot be determined because the changes in implied volatility will affect the premium of the long call.

Conclusion

The similarity between covered calls and time spreads stems from the potential profit source of the short call. But the difference is important to understand. With a time spread, the protective asset is a limited-risk call instead of the much-larger-risk stock or equity position.

A position even more similar to a covered call — called a diagonal spread — can be established if the long option has a lower strike than the short option. That, however, is a blog for another day.