Option Trading Strategy: Trading as a Business Video 3 Part 15

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In a calendar spread, we know that the front month – in other words, the month that is the very nearest to the expiration of this particular underlying stock – is June, in this case. It has 27 days left. There’s also June quarterlies over here. There’s another June in here. I think it might even be a weekly.

They have a lot of different kinds of option contracts. The one that we’re interested in are the front months. The very next expiration month is called the front month.

What we’re doing, is we’re selling an option. Of course, because we don’t like unlimited risk, we also want to buy an option, right? Just like in a vertical spread. Well, in the case of a calendar, the only difference is, instead of buying an option in the exact same month, is the one that we’re selling. We are going to actually go into the next month, which is July, and we are going to buy the exact same strike price, only a different month.

We are selling a June 138 call, and we are buying a July 138 call. Let me show you exactly what would happen, if you did not buy that call in July, for protecting the sale of that June call. Let’s analyze this.

You can see that, if the price stays the same, or it goes down, like you intended – you would collect the maximum profit. In this case, it’s what you sold this option for, which is $2.59, or $259. However, because you do not have any protection for that option that you sold, you have a theoretical unlimited loss potential on that option, if it goes against you.

You sold the call option. You want the stock price to go down. But what happens if it goes up? Let’s take a look. If it continued to go up, and up, theoretically, it could go to $1,000, although this is an index. You would have a maximum loss of $86,574. Which is not a pleasant thing to have happen.

So, we do not sell naked options. What we want to do is, we want to protect that position, by buying another option at the same strike price, only in a different month. This is called a calendar spread. They call it a calendar spread because you’re selling in one month, and you’re buying in another. Let’s analyze this.

This is what the graph of the profit potential of this position looks like, when we have both the sale of the call, and the purchase of the call, in the next month out. The purchase of this call provides us with protection. If the price was to move against us, we would have a limited loss on the position.

Our maximum gain and maximum profit on the position, is achieved at the exact price that we sold this call for. In this case, it’s the $138. That’s the strike price of the call that we sold. We would achieve the maximum profit if, at expiration, this stock remained exactly at $138.

We have a fairly wide breakeven range here, between 142 and 134.25, approximately. In other words, the price can move to either range, and we will still achieve some profit.

However, unlike the naked call, we also have limited risk to the downside. If the stock had gone up to 1,000, like we had in our previous example, the very most you could lose, on this particular calendar spread, is $136. I’ll show you why it’s only $136 in just a minute.

Essentially, what you’re doing is, you’re protecting the one that you sold, with another one at the exact same strike price, only in a different month. You’re hoping to achieve the maximum profit, and the Theta decay, of the front month option that you sold, while trying to maintain the value of the one that you bought, in the July month. Let me show you what this looks like, if these options were put together on a graph.

You can also see that Theta is positive, at 1.26. Even though you’re buying an option, you’re also selling one. Even though they’re at the exact same strike price, because they’re at different months, it gives you a positive Theta.

Also very interesting is, unlike a vertical spread that you would sell, it also gives you a positive Delta.

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