“Only the pros can trade options.”
This is probably the most common delusion about options that’s out there, aside from options being too risky.
But quite the contrary…
Every day, more and more people use options as their trading or investing method. Whether it’s to protect a portfolio of stocks or to take a small, leveraged position to control a larger quantity of stock, options are a great way to profit off any market condition.
Say, for example, that you’re a long-term investor who’s concerned about the safety of your portfolio. You can use options as insurance to help minimize the risk of a correction in the markets.
Likewise, say you want to get in on a hot new tech stock but don’t want to put a lot of capital into a position. Options trading could be the perfect answer for you.
Now last week, we talked about a strategy you can use to start generating income on a monthly basis. But this required you to own the stock in question – something you may not want to do.
So today, I’m going to show another easy way to make money without needing to own the stock first.
And this powerful play could help you squeeze time for cash… and set you up for endless profit potential.
Use the Calendar Spread to Make Money Quickly and Easily
As you’ll recall on Friday, we talked about writing covered calls to generate monthly income. This is a strategy you can consider using when you own a stock that you don’t expect to move much higher any time soon. And this is definitely an outlook you may have from May through November (when the markets historically don’t perform that well).
Now I’ve taught this strategy to thousands of students over the world. And the biggest concern for many of them is the “covered” part. “Covered” simply means you own the stock. So if you don’t already own the stock, you’ll have to buy at least 100 shares of the stock (one contract equals 100 shares) before you execute this strategy.
Understandably, this may not be something you want to do – especially if the stock is expensive.
Take, for example, Amazon.com, Inc. (NASDAQ: AMZN). Right now, the stock is trading at around $708. So buying that 100 shares you need to write covered calls will cost you no less than $70,600.
Now that may be manageable to for some people… but to others, that could be an entire year’s salary.
So let me show you an options strategy that can allow you to participate in an expensive stock like AMZN – without all that up-front cost…
Introducing the Calendar Spread
A “calendar spread” (or “time spread”) strategy is similar in concept to covered call writing. But this strategy does not require you to own the stock first.
A calendar spread is a two-legged options trade where you buy a longer-term option and sell a shorter-term option with the same strike price. When using this strategy, you must choose calls or puts to buy and sell; you cannot buy a call and sell a put, for example, or buy a put and sell a call.
What you’re basically doing is using a longer-term expiration option, such as a Long-term AnticiPation Securities (LEAPS) instead of buying that 100 shares of stock you’d need to write covered calls.
What you’re also trying to do is profit off of the rate of “time decay” between the two options. Time decay, or theta, is the change in price of an option with respect to a one-day change in its time until expiration. It measures the amount an option will lose with the passage of one day.
Time decay is larger in the shorter-term options than the longer-term ones. This means, based on time decay alone (and with the stock just staying basically at the same price), shorter-term options depreciate in value faster than the longer term option. So if a stock is not moving in your favor, and you’re holding onto it, time decay is eating away at the value of your option.
And that’s where the calendar spread comes to the rescue…
Let’s look at this strategy closer using AMZN as our example.
I know that AMZN has been cranking higher in price, and I want to use it to really emphasize how you can use a calendar spread to significantly lower the cost you’d otherwise face when writing covered calls. I’m not actually making a trade recommendation on AMZN.
As you can see above, one contract of the AMZN January 2017 $710 calls
is quoted between $72.75 and $73.40. You’d typically buy at the higher ask price, so we’re looking at the $73.40 price in this scenario, which equals a cost of $7,340 (100 shares per contract x the ask price of $73.40).
Now this may seem like a lot of money, but $7,340 is a whole heck of a lot less than $70,600 to spend on a trade.
But you could reduce your cost even more if you can save yourself from needing to buy the stock first. That’s where a calendar spread comes into play…
With a calendar spread, you are buying a longer-term option (in this case the AMZN January 2017 $710 calls).
You’re then going to look for options with expirations between four and six weeks (or less), similar to the covered call strategy, to see the selling price of an option with the same strike price.
Remember… calendar spreads and covered call writing should be considered when you anticipate the stock staying pretty flat or moving only slightly higher between the time you open your position and the expiration of the month you sell.
Here’s an options listing for an AMZN June 2016 week 3 $710 call for the selling side of the spread:
To sell this, you’d typically use the lower bid price, which is $14.85. And since one contract equals 100 shares, the total amount you’d bring in is $1,485.
Now let’s compare the rates of return with the calendar spread and covered calls if AMZN stays under $710…
Covered Call Strategy
Using this strategy, you would have to buy 100 shares of AMZN before executing. This means you’d need to spend $7,600 to own 100 shares. The premium you brought in from the sale of the $710 call you sold against your stock would be $1,485. This is a 2.1% rate of return ($1,485 / $70,600).
Calendar Spread Strategy
Using this strategy, you would not need to buy 100 shares of AMZN before executing. So your cost upfront to enter the trade would be $7,340 instead of $70,600. And the premium you brought in from the sale of that $710 call would still give you $1,485, bringing your rate of return from 2.1% to 20% ($1,485/$7,340).
And that’s just of the sale of the premium alone for June. If AMZN stays under $710 after expiration, you, you can repeat the process – and generate more income.
With calendar spreads, you have less risk because you spent less money. And the cost of a longer-term option, like a LEAPS option, is much less than buying the stock outright – which means you have greater profit potential.
Three Good Reasons to Consider the Calendar Spread
Beyond saving you thousands of dollars, here are three good reasons for you to consider using a calendar spread:
- Reduced Risk
Your risk in any trade is your total cost. Since you are spending less to open a position that you wish to sell options against, your risk is also less. Additionally, you’re further reducing your risk in by selling options against the option you bought. And you’re bringing in money to offset the cost of the longer-term option.
You can turn this into a net long call option position if you see the stock taking off or about to break out even higher than you originally anticipated. You may have to buy to close the sold option at a bit of a loss, but by keeping the long call you can be in position to make money over and above that loss by the increase in value of the long call position.
- Reduced or Zero Margin Requirements
Now, I will NEVER recommend selling naked options because it is just too risky. But if you do, there is going to be a margin requirement set aside in your account that you can’t use while the naked trade is open. The shorter-term call option you are selling against the longer-term option is considered an offsetting position and will significantly reduce, or eliminate, your margin responsibility.
And one last advantage of the calendar spread strategy that I like to point out is this…
Every time you write or sell a call against either your stock or your longer-term option position, you’re reducing your cost basis.
Generating, say, a $1,485 profit every month from selling calls can quickly cover… or should I say recover… the total cost of that longer-term options contract than it can the cost of buying the stock outright.
Here’s Your Trading Lesson Summary:
Last week, we talked about covered calls and how they can help you generate monthly income. But to use this strategy, you must own the stock first. If you don’t, then you need to buy the stock… and that could be very costly. If you don’t own the stock already and do not want to buy the stock first, consider using a calendar spread, where you:
- Don’t need to buy the stock first
- Reduce your risk
- Set yourself up for endless profit potential
Until next time…