Education: Calendar Spread Option Strategy

Overview

Have you head of the saying “Lull before the storm”? This is quite common in stock markets. Markets tend to be quiet, with sideways movement in a small range before big moves in either direction. So how do we deal with such markets? We know that options have time limitations. And, we are able to purchase options that expire in any of the three months (series) including the current month. So if we feel that the stock price will be quiet without much movement till the current month’s expiry and might give big moves up or down in the next month, we can opt for the Calendar Spread option strategy. This strategy takes advantage of time decay and gives return in short term even if the stock price moves sideways/in a range. It also gives us security in case the big move happens suddenly, before the expiry of the current series itself.

How to Execute?

We can either implement this strategy with Call or Put options. Let’s assume that we have analyzed the stock price to move in a small range for the current month, but expect it to give big move upwards in the next month. In this situation, we sell a slightly Out-Of-The-Money (higher strike) Call that expires in the current month, and buy the same strike Call that expires in the next month.  For example, if Nifty is currently trading at 5000 and we believe it might be range bound between 4950 and 5050 in this month, we can sell 5100 strike Call expiring in the current month, and buy 5100 strike Call expiring in the next month. So if Nifty remains in the range till the current series expiry, the 5100 Call that we sold loses premium quickly and we can cover it by buying at lower price, thus making quick profit. Further, if as per our expectation, Nifty breaks out of the range and moves up in the next month, we can hold the 5100 Call that we bought and gain profit too. However, in the event of Nifty breaking out of 5100 range in the current series itself, still the loss that we make in the short position of the 5100 Call (current series) is capped by the long position in the 5100 Call that is expiring in the next series. Good deal isn't it?

How to Exit?

In case the market remains range bound, we can leave the short position and pocket the premium. Depending on the market trend, we can then deal with the long option that expires in the next series. However, if the stock price breaks out above the range before the expiry of the current series, then we cover the current series Call option (short) and hold the next series Call option (long).

[Note: ‘Long’ means bought position and ‘short’ means sold position. In case we are long, we need cover the position by selling the option. In case we are short, we need to cover the position by buying the option.]

Hope this will be useful. Comments are most welcome. In my next education series post, I will discuss Bear Call Spread and Bear Put Spread option strategies, both of which are ideal for a bear market.

Cheers!