One well researched investment strategy keeps a large chunk of capital in ultra-safe government debt and deploys the remainder — say, 10% over the course of a year — in call options. Calendar spreads can provide an attractive follow-up for this strategy, enabling an investor to exploit downturns like the recent June swoon.
The well known Treasury bill/option strategy (also known as 90/10) purchases out-of-the-money calls with a relatively small amount of capital on a rolling basis throughout the year, keeping the remainder in a virtually risk-free investment such as government debt. Designed to limit risk by keeping 90% or more of capital entirely safe and drawing interest (ah, those were the days), the strategy also provides exposure to what may potentially become very large gains via out-of-the-money call purchases. The thinking is that a series of small losses on calls expiring worthless can be more than offset by the value of calls that less frequently generate large gains.
Although it may sound decidedly pedestrian and unglamorous, the approach has been well researched and is regarded by many as one of the most mathematically appealing basic strategies available.
While it is probably more common to apply the strategy by buying a sequence of shorter term calls, there is also merit in buying longer term calls instead, specifically so as to enable calendar spreads as a follow-up strategy when the underlying security moves in a favorable direction. The advantage is that the short portion of the calendar spread can often be sold more than once before the longer term call reaches expiry, and when the underlying security moves in an unfavorable direction such as the recent June swoon, the investor can use that move to lock in gains on short positions by closing them, rather than merely watching value drain from the longer term long calls. As with all calendar spreads, this follow-up becomes less appealing with more out-of-the-money calls; it is more appealing after the underlying security has appreciated.
An investor using this strategy might consider targeting out-of-the-money index or broad ETF calls which are 9-12 months out. In early April, for example, I found that SPDR S&P 500 (SPY) calls at 171 in the March 2014 series and PowerShares QQQ (QQQ) calls at 80 in the January 2014 series were trading around $2.62 and $.38, respectively. Without going into the details of the rationale behind these particular strikes — that’s another article altogether — within a few weeks both sets of calls had appreciated by a couple of hundred percent. When this happens, the investor buying longer term out-of-the-money calls faces a choice: leave the position to run, risking all the gains achieved so far in return for unlimited profit potential, or attempt to hedge the position to protect some portion of the gains. In the case of applying the calendar spread follow-up, the idea is to sell a shorter term call at the same strike — the July series was particularly attractive — knowing that the time value of the shorter term call which is being written will decay much more quickly than the time value of the longer term, long option. As a result, the spread between the two widens as time passes. (Even now, an investor holding these particular calls could sell the October SPY at the 171 strike for $1.26 per contract, or nearly 50% of the original purchase price. One could even enter them today at an ask of $4.07, immediately creating a calendar spread by writing the October expiry to reduce the position cost to just $2.81, although doing so would represent simply entering a calendar spread from the start, as distinct from using it as a follow-up in response to appreciation in the underlying security.)
Once an initial long call has appreciated as a result of the underlying security’s move upward, entering a calendar spread by writing a shorter term call at the same strike essentially protects some of the gain which has already been achieved. If the underlying security should continue to climb strongly, it may at some point become preferable simply to close the spread and keep the profit — profit which could wind up being smaller than if the investor had simply left the original long call to run and the underlying security kept climbing. On the other hand, if the underlying security fails to reach the strike by the time of the short call’s expiry, then often it can immediately be sold again with a later expiry. Finally, if the underlying security falls significantly in what the investor believes to be a temporary retreat, the short call may be closed and written again later if and when the underlying security recovers.
The overall impact of applying this follow-up strategy is to enable the otherwise long investor to profit from short term downturns, to hedge gains when they occur, and potentially to achieve larger gains than with no follow-up at all, due to the potential for writing the short portion of the calendar spread multiple times. The downside of these benefits is that on those occasions when the underlying security continues moving smoothly upward, the investor may need to close the spread sooner than they would have closed a single long position, thereby forfeiting whatever gains could have been achieved had the long call simply been left to run.
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