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Calendar Spreads Tweak #3:
Calendar Spreads Tweak #3: You buy calls when you hope the stock is headed higher and you buy puts when you hope the stock will tank. For that reason, most people associate calls with a bullish outlook and puts with a bearish outlook.
With calendar spreads, this association does not hold water. Let’s check it out in the real world. Here is a typical calendar spread you might place on Facebook (FB) while the stock is trading at just over $130 with a little over a month to go before the 14Oct16 options expire:
Buy To Open 1 FB 20Dec17 130 call (FB170120C130)
Sell To Open 1 FB 14Oct16 130 call (FB161014C130) for a debit of $4.93 (buying a calendar)
Here is what the risk profile graph shows will be the loss or gain on this spread at various possible closing prices at the close of business on October 14, 2016 when those calls expire:
You can see that if the stock is absolutely flat, the spread will gain $164. The break-even range extends a little over $3 in either direction. Any closing price within that range would result in a gain for the month of waiting for time to expire.
Let’s compare this graph with the same calendar spread, but this time using puts rather than calls:
Note that the gain with a flat stock price is precisely the same, as is the length of the break-even range. It doesn’t matter whether you use puts or calls. When you buy a calendar spread, the important thing is the strike price. You buy the spread at the strike price when you think the stock will end up at some future date. If the stock is indeed at that strike price on that date, your calendar spread will reach its maximum profit.
While this suggests that it doesn’t make any difference whether you buy puts or calls, there are two ways that one choice might be better than another. First, the cost of buying the spread might be different if you choose puts rather than calls. In the above example, the call calendar spread would cost $4.93 and the same spread using puts would cost only $4.62.
Why would you pay $.31 more to buy the call spread when the expected gains or losses would be precisely the same whether puts or calls are used? In short, you shouldn’t.
In this case, there is a second reason to use puts for the spread rather than calls. Most stock prices move higher over time, so the chances of FB being slightly above $130 is a little greater than the chances of its being below $130. If it does manage to be higher than $130 on October 14, the puts that are expiring on that day will be out of the money (i.e., they will expire worthless if you don’t do anything) so you won’t have to buy them back.
On the other hand, the calls will be in the money, meaning that they will have a value which is exactly the difference between the strike price and the current price of the stock. You will need to buy them back on that day to avoid their being exercised, regardless of whether you wish to close out the spread or do something else (such as roll them over to some further-out expiration date, collecting additional cash).
In general, people don’t like to own short-term in-the-money options. Since they have an intrinsic value (in addition to their time premium value), they are more expensive than at-the-money or out-of-the-money options. Because of this relatively low interest level, the short-term in-the-money options tend to have a larger bid-ask spread. This means that it is often difficult to get decent execution prices.
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On expiration day for FB, it is not uncommon for there to be a $.20 gap between the bid and ask price of the just in-the-money expiring option, while only a $.05 gap (and sometimes as low as $.01) between the bid and ask of the out-of-the-money option. Even better, you don’t even have to buy back the expiring out-of-the-money option if you don’t want to. You could just wait until the following Monday to sell your uncovered long option that you bought when you first got the calendar spread.
Bottom line, if you think the stock is headed higher than the strike price by the time your short options expire, you are better off buying a put calendar spread rather than a call calendar spread, especially if the initial cost is lower. I admit that it is not intuitively logical to be dealing in puts when you expect the stock to be headed higher, but that is the way it is when you are trading calendar spreads. The strike and the original cost rules in the world of calendar spreads.
Happy trading.
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