WMT (Walmart) looks to be setting up for some serious considerations on this type of trade. With Earnings today flat, and movement is not overly volatile, this trade could pay off. However, I need to set my exit plans and crunch some numbers. I will be waiting for early next week before I make a move...If I make a move.
I am defining 48 as some strong support and with the move today and going into the weekend I will be watching to see if it holds or we go lower.
Education Segment:
The neutral calendar spread strategy or call calender, involves buying long term calls and simultaneously writing an equal number of near-month at-the-money or slightly out-of-the-money calls of the same underlying security with the same strike price.
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Sell 1 Near-Term ATM Call
Buy 1 Long-Term ATM Call |
The options trader applying this strategy is neutral towards the underlying for the short term and is selling the near month calls to profit from their rapid time decay.
Limited Profit Potential
The maximum possible profit for the neutral calendar spread is limited to the premiums collected from the sale of the near month options minus any time decay of the longer term options. This happens if the underlying stock price remains unchanged on expiration of the near month options.
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| Neutral Calendar Spread Payoff Diagram |
Limited Downside Risk
The maximum possible loss for the neutral calendar spread is limited to the initial debit taken to put on the spread. It occurs when the stock price goes down and stays down until expiration of the longer term options.
Example
In June, an options trader believes that XYZ stock trading at $40 is going to trade sideways for the next few months. He enters a neutral calendar spread by buying a OCT 40 call for $400 and writing a JUL 40 call for $200. The net investment required to put on the spread is a debit of $200.
As expected, the stock price of XYZ closes at $40 on expiration date of the near term call and the JUL 40 call expires worthless. The long term call lost some value due to time decay but is still worth $350. Selling this call nets him a $150 profit after taking into account the initial debit of $200.
If the price of XYZ had instead declined to $37 and stayed at $37 until October, both options expire worthless. The trader will also be unable to write additional calls since they are too far out-of-the-money to bring in significant premiums. Hence, he will lose his entire investment of $200, which is also his maximum possible loss.
Follow-up Action on Near-Term Expiration
Like all calendar strategies, it is necessary to decide on which follow-up action to take when the near-term options expire. This decision depends heavily on the revised outlook of the underlying stock at that time.
Should the neutral calendar spread trader thinks that the underlying volatility will remain low, then he may wish to enter another calendar spread by writing another near term call.
If he thinks that the volatility is likely to increase significantly, he may wish to hold on to the long term call to profit from any large upward price movement that may occur.
However, if the options trader is unsure of what to expect of the underlying, it may be best to take profit (or loss) and move on to evaluate other trading possibilities.
Note: While we have covered the use of this strategy with reference to stock options, the neutral calendar spread is equally applicable using ETF options, index options as well as options on futures.
Commissions
For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.
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