WHAT IS LONG CALENDAR SPREAD WITH CALLS STRATEGIES?

 

Introduction to long calendar spread with calls

 

   A long calendar spread with calls is a strategy used in options trading that involves purchasing a long-term call option while simultaneously selling a short-term call option on the same underlying asset with the same strike price. This strategy is primarily deployed by traders when they expect the stock price to remain relatively stable in the short term but anticipate more significant movements over the long term. It allows traders to benefit from time decay in the short-term option while gaining from potential price increases in the long-term option.

 

   The strategy capitalizes on the concept of options "decay" over time, known as theta decay, where the value of short-term options declines more rapidly than long-term options as the expiration date approaches.

 

Components of the strategy

 

The long calendar spread with calls consists of two key components:

 

Long call (Long-term):  This is the option that you purchase. It usually has an expiration date that is further in the future, allowing you to retain value longer. The main purpose of buying this long-term option is to capitalize on future potential movement in the underlying asset.

 

Short call (Short-term):  This is the option that you sell, which expires sooner than the long call. The goal is to profit from the time decay of this option, as short-term options lose value more quickly than long-term ones.

 

   By combining these two elements, the trader creates a spread that profits from the faster time decay of the short call relative to the long call while also positioning to benefit from potential stock price increases over the long term.

 

How the long calendar spread works

 

To better understand how this strategy works, let's break it down step-by-step:

 

Step 1: choose the strike price and expirations

 

   First, select an underlying stock or asset on which you wish to execute the calendar spread. After choosing the stock, the next step is selecting a strike price, which is the price at which both the long and short call options will be exercised if the option holder chooses to exercise them. Ideally, the strike price should be near the current price of the underlying asset, as the strategy performs best in a low-volatility environment where prices stay relatively flat.

 

Then, choose two expiration dates:

 

Short-term call:  Sell a call option that expires in the near future.

Long-term call:  Buy a call option with a much later expiration date.

 

Step 2: establish the position

 

   After selecting the expiration dates and strike price, execute the trade by buying the long-term call and selling the short-term call. Since the trader is selling the short-term call, they receive a premium, which helps offset the cost of the long-term call. However, the initial outlay is still a net debit because the long-term call will be more expensive due to its longer expiration.

 

Step 3: monitor the trade

 

   After the trade is initiated, the trader needs to monitor the underlying stock price movement and the impact of time decay. The objective is to profit from the difference in time decay (theta) between the short and long calls. If the stock price remains stable or does not move too far from the strike price, the short call will decay faster than the long call, allowing the trader to potentially close the position at a profit.

 

Key concepts involved

 

The success of the long calendar spread with calls relies heavily on an understanding of a few key options concepts, such as:

 

1. Theta decay (Time Decay)

 

   Theta is the rate at which an option's value declines as time passes. Options lose value as they get closer to expiration. The time decay is more pronounced in short-term options, which is why traders sell short-term options in a calendar spread. As the short-term option loses value quickly, the long-term option retains more of its value.

 

2. Volatility

 

   Volatility plays a crucial role in the success of the calendar spread. A long calendar spread is typically set up when the trader expects low volatility in the near term and a potential increase in volatility in the long term. Low volatility helps keep the stock price close to the strike price of both calls, allowing the short call to expire worthless, while the long call benefits from any price movements later on.

 

3. Strike price and timing

 

   Choosing the correct strike price is vital in a long calendar spread. The strike price should generally be at or near the current stock price. The nearer the stock price is to the strike price, the more the short call option will decay due to theta decay, which is favorable for the spread.

 

Advantages of the long calendar spread with calls

 

Theta profit potential:  The main advantage of this strategy is the ability to profit from time decay in the short-term call option, which loses value faster as expiration approaches.

 

Cost efficiency:  The premium received from selling the short-term call helps offset the cost of purchasing the long-term call. This makes the strategy less expensive than simply purchasing a long-term call by itself.

 

Limited risk:  The maximum risk in this strategy is limited to the net debit paid to establish the position. The maximum loss occurs if the stock price moves too far away from the strike price, either too high or too low, and neither option gains value.

 

Flexibility:  The long calendar spread can be adjusted as market conditions change. For instance, if the short call option is about to expire and the underlying stock has remained near the strike price, the trader can sell another short-term call to continue benefiting from time decay.

 

Risks and disadvantages of the strategy

 

Limited profit potential:  While the long calendar spread offers a favorable risk-reward profile, the profit potential is somewhat limited. The ideal scenario is for the stock price to remain at or near the strike price as the short-term call expires.

 

Stock price movement:  If the stock price moves significantly away from the strike price, either up or down, the strategy can become unprofitable. A significant increase in stock price could result in losses on the short call, while a significant decrease could make both calls worthless.

 

Implied volatility risk:  The success of the long calendar spread depends on volatility. If implied volatility decreases after the position is established, the value of both call options will decline, potentially leading to a loss on the spread.

 

Adjustments and exit strategies

 

In options trading, it is essential to manage the position and make adjustments if market conditions change. A few potential adjustments for the long calendar spread include:

 

Rolling the short call:  If the short-term call option is about to expire and the stock price remains close to the strike price, the trader can roll the short call to a later expiration date to continue collecting premium from time decay.

 

Exiting the trade early:  If the trade becomes profitable before the short call expires, the trader can exit the position by closing both the short and long calls simultaneously. This allows the trader to lock in profits before potential market movements erode gains.

 

Closing at expiration:  If the stock price remains near the strike price when the short call expires, the trader can simply close the position or sell another short-term call to continue the trade.

 

Example of a long calendar spread with calls

 

Let's consider an example of a long calendar spread with calls on a stock currently trading at $100. A trader might:

 

Buy a long-term call:  Buy a call option with a strike price of Rs.100 and an expiration date six months away, paying a premium of Rs.5.

 

Sell a short-term call:  Sell a call option with the same strike price of Rs.100 but with an expiration date one month away, receiving a premium of Rs.2.

 

The net cost of entering this position would be Rs.3 (the difference between the Rs.5 paid for the long-term call and the Rs.2 received from selling the short-term call). If the stock price remains around Rs.100 over the next month, the short-term call will lose value due to time decay, and the trader can either exit the trade or roll the short call into the next expiration cycle.

 

Conclusion

 

   The long calendar spread with calls is a sophisticated options strategy designed for traders who anticipate little short-term movement in an underlying asset but expect more significant movements in the long term. This strategy benefits from the time decay of the short-term call while positioning the trader for potential price increases with the long-term call. Understanding the dynamics of volatility, theta decay, and strike price selection is crucial for maximizing the effectiveness of this strategy.