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The stock market just finished one of its best years in history.
2019 saw new market highs from all three major indices, and investors across the country are swimming in profit.
It’s easy to make money when the market is heading up. You know how the old adage goes… buy low, sell high.
But here’s the thing – stocks won’t always be rising. Sometimes they fall. Sometimes they barely move at all.
That’s why today, I want to show you a strategy that allows you to make money even if your stock goes nowhere.
Here’s how to cash in on a sideways-moving stock – before it falls…
Profit in Multiple Directions with a Calendar Spread
Let’s say you’re bullish on a stock. But you also want to make sure you won’t lose a bunch of cash if you’re wrong. They say you can’t have your cake and eat it too – but with options, you can.
By combining stock options into what’s called a “spread,” you can make money in multiple directions. With a calendar spread, you can make money if the stock goes up or sideways.
It’s constructed by buying a long-term option and selling a short-term option at the same strike price.
Here’s an example…
On September 27, 2019, we had a bullish prognosis on Boeing Co. (NYSE: BA) that forecasted an $8.50 rise over the next 40 days.
Now, you could have bought the stock, sure. But 100 shares of
BA would have ran you $35,473. That’s a ton of cash to fork over for a single trade, if you ask me.
So, let’s say you turn to options. They’re less expensive than buying shares. An October 18, 2019 $370 call was running around $10.10, or $1,010 for control over 100 shares. Obviously, you’re saving a ton with fantastic leverage.
This call option would have increased in value if BA were to go up in the next 40 days and bring approximately 10x the return compared to simply buying the stock.
But if you were wrong, and the stock didn’t move, you would have watched that call option slowly shed its time value, essentially robbing you of any profit potential.
Now, with a calendar spread, you could have slashed your initial cost by a whopping 50% and created a trade that would profit whether BA moved up or simply sideways.
All you had to do was sell a call option at the same strike price in a closer month. At the time, the September 20, 2019 $370 calls were going for $5.15. By combining the long October $370 long calls with the September $370 short calls, you could have created the following trade:
Buy Oct 18, 2019 $370 Calls -$10.10
Sell Sep 20, 2019 $370 Calls + $5.15
Total Debit $4.95
This position would have cost you a total of $495 to control $35,473 of Boeing stock. That’s a 99% reduction in cost!
Now, it’s important to realize that the total risk in this calendar spread would have been your $495 debit.
You see, the long October 18 $370 calls gives you the right to buy the stock at $370, and the short September 20 $370 calls obligate you to sell the stock for $370. That means your rights and obligations canceled each other out – the perfect recipe for profit.
In order to understand how these two options interact, take a look at this “risk graph.”
A risk graph translates stock price to profit/loss (P/L) over time. As you can see above, the profit zone is approximately between $354 and $391. Our bullish prognosis had the stock going up $8.50 to $363, well beneath the upper breakeven line of $391.
The red, blue, and green curvy lines on the risk graph illustrate the P/L in the trade over time with the black “witches hat” line representing the expiration of the short call on September 20.
As you can see, as time progresses from red to blue to green, more profit is added to the position as long as the stock is in the profit zone.
23 days later, on September 19, BA had risen 8.37% to $384.44.
So, how did the calendar spread do?
As you can see above in the risk graph, the calendar spread produced $71 (14.34%) in profit. That’s nearly double the profit you would have made from buying the stock!
To exit a calendar spread, simply “put the battery in the other way around.” Buy back what you sold, and sell what you bought.
Here’s the closing order:
Sell Oct 18, 2019 $370 Calls +$20.47
Buy Sep 20, 2019 $370 Calls – $14.81
Total Credit $5.66
So, you could have sold your calendar spread for $566.
The original debit was $495, leaving a $71 (14.34%) profit.
Of course, buying more calendar spreads will produce more profits. 10 contracts of this calendar spread would have produced $710 in profits with $4,950 in risk, for example.
Three Rules to Creating a Calendar Spread
- Buy 60-day calls with strike price at anticipated price target.
- Sell 30-day calls at same strike price.
- Exit if any of the following occur:
- Stock closes outside of profit zone (outside of break-evens)
- 1-3 days to expiration of short option.
- 50% profit
If you don’t have access to risk graphs and don’t know your break-evens, then simply exit your calendar spread at a 25% loss.
With practice, you’ll be trading calendar spreads like the pros in no time!
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To your success,
Tom Gentile
America’s #1 Pattern Trader
