I have received many requests from Tycoon Report readers looking for a little clarity on a stock option strategy called the "Calendar Spread" (aka "Time  Spread").

A calendar spread gets it's name because the strategy involves two options that expire in different months.  The strategy is created with the (short) sale of an option that expires in one particular month while simultaneously owning (being long) another option that expires in another month.  The options must be on the same underlying security.  The strike prices can be the same or different.

If the strike prices are the same, it's a "horizontal spread" and if they are different, it's a "diagonal spread".

A horizontal call spread may look like this:

Long XOM June 50 call
Short XOM July 50 call

A diagonal call spread may look like this:

Long XOM October 50 call
Short XOM June 60 call



The specific type of Calendar Spread that I use quite often is the "diagonal call spread".  It has made members of my option trading service lots of extra profit, and has saved us from taking some losses when things didn't go our way.

This is by no means a complex strategy that you should feel intimidated by. As a matter of fact, it's really quite simple.

Pay close attention, because not only are we in a market that is 100% perfect for a strategy like this, but this strategy can turn a 150% gain into a 300% gain while reducing your risk exposure at the same time. The strategy works best when you are fairly neutral on the near-term prospects of a stock, but still bullish over the longer-term.

For those of you who sell (or write) covered calls against your stock positions, this should be an especially easy concept to grasp, since it is almost the same thing. The difference is that, instead of selling a call option against a stock that you own, you are selling a call option against another (longer term) call option that gives you THE RIGHT to buy a particular stock.

Okay folks, here we go …

As you may know, the majority of option traders are speculating on market direction, even though they're wrong most of the time. Usually you hear about the most basic form of option trading, and that is when you buy a call option at one price (the call gives you the RIGHT to purchase XYZ stock at a designated price sometime before its expiration date), and then hope the stock moves higher, which will push that call option up several percentage points higher.

I tend to agree with using this basic strategy, as long as you are doing it in the most conservative fashion possible. When you do it my way (by purchasing "high delta calls"), you are reducing your risk of time decay by purchasing call options that expire in at least 6-12 months, and the call options should be deep in-the-money, but that's another story.

You probably also know that the seller of an option (the person who writes the option contract and sells it to the buyer or speculator who we described two paragraphs up) takes advantage of the same odds that the buyer is working against. If the buyer of an option is usually wrong, then that means that the seller is usually right.

What happens to the riskier options is that the price of the option erodes as time passes. We call this time decay. The buyer of an option who is looking for a 467% return in 2 months is willing to risk everything for that huge gain. Time decay usually wins.

The seller (aka. writer) of the option uses time decay to his advantage.

Like I said, you have the riskier options and the more conservative options. If the buyer of a call option is likely to pay $4.00 for a higher risk call option only to see it trade to zero, that means that on the other side of the trade, there is a seller of an option who sold it (Shorted it) at $4.00, and is likely to see it trade to zero, which would be a profit for the seller (and a loss for the buyer).

The Strategy:

I have mentioned in the past that I've used this particular strategy to reduce my cost basis on an option that the members of The Trend Rider bought back in October. Well, since then I have reduced the cost basis a few more times. I actually reduced it from $15.20 to $6.40!

Again: a diagonal call spread works best when you are somewhat neutral on the near-term prospects of a stock, but still bullish over the longer-term.

When you use a diagonal call spread, you basically sell (short) a near-term option with a higher strike price, while you own (are long) a longer-dated option (an option with much more time before the expiration date) with a lower strike price.

It allows you to generate additional income while you wait for the upside run to continue.

For example, let's say that XYZ is trading at $37.50, and say you own the XYZ January 30 call option. This gives you the right to buy XYZ at $30.00 some time before the third Friday in January.

While you are waiting for that to happen, you can sell someone the right to buy XYZ from you at $40.00 some time before options expiration day in July, which is an option that is more likely to expire worthless.

Remember, you don't actually own XYZ, but just the RIGHT to buy it if you want to. You are considered to be "covered" in this strategy because if you are "called" upon to deliver the stock at $40.00 to the person who bought the July 40 call from you, then you can exercise the other call that you are long (that you own) and buy XYZ at $30.00, and then deliver (or sell) XYZ to the person who is "calling" upon you to deliver (sell) the stock to him.

The shorter-term option you sold loses value much more quickly than the option you bought. An option loses value rapidly in the last 30-45 days before expiration.

What I have been doing with Suncor Energy calls is simple. I recommended buying the 2007 January 45 calls back in October, when the stock was at about $52.50. Now my members have the RIGHT to buy Suncor at $45.00 any time before options expiration day in January 2007.

When the stock hit $75 on January 23, 2006, I recommended selling the Suncor Energy Inc. February 75 2006 call for $3.70. That reduced my cost basis from $15.20 to $11.50!

I sold more short-term calls that were likely to expire worthless, over and over again.

Sometimes they expired worthless, and sometimes they were bought back.

On February 7, 2006 I recommended selling the March 75 calls for $6.00.

Then, as the stock traded higher and higher, I sold more short term calls on April 18 and again on May 25th.

Long story short, every time I sold short term call options I reduced the cost basis on the original call option that I owned (the 2007 January 45 call option). That call option has traded up to the mid 40s, and today fluctuates just under $40.00. My members still own it, and instead of owning it from $15.20, we have taken in premium after premium by selling the short term calls to the major risk takers, bringing our cost basis down to $6.40.

That means that we have taken in a total of $8.80 in extra premiums by selling the short-term calls to those high risk takers.

Now remember: If any of those high risk takers had won, that would mean that I might be obligated to deliver (sell) Suncor stock to the person who bought the call option that I sold.

So for example, if I sold the March 75 call option, and the stock had traded up to $85.00, then I would have been obligated to deliver the stock at $75.00.

In this case, I would exercise the 2007 January 45 call option that I bought originally to buy Suncor at $45.00, and I would deliver (sell) Suncor at $75.00 to the high risk taker who is calling the stock away from me.

That means I make 30 points on the stock (75-45), and I also make the premiums that I collected from the risk takers who had bought the short term call options that I sold (wrote) in the past.

(Keep in mind that if you are using a broker that understands options, you shouldn't have to ACTUALLY use your long 2007 Jan 45 call to buy the stock at 45 and deliver it at 75. If you did this, you would lose your extrinsic value.  Instead, the best thing to do it cover the newly created short stock position in your account and simultaneously sell out of your long call - 2007 Jan 45 call- position.  But that's another story and I want to stick to the point.  So going forward, when I say I would be forced to deliver stock, the reality is that a good broker wouldn't make you do that.)

If I sell the July 90 call today, and the stock trades to $100.00, then someone will be calling Suncor away from me at $90.00. I will be forced to deliver the stock at $90.00. That means that, on the stock transaction, I will make $45.00.

But remember, over the last 7 or 8 months, we have collected a total of $8.80, which reduced our cost basis down to $6.40! That means that when I make $45.00 on the stock transaction, it will be on a $6.40 cost basis instead of our $15.20 original cost basis. On one hand, we could look at that as a 603% gain because I reduced my cost basis. 

But since we are talking real dollars here, that means that instead of making 196% (the sale of $45.00 on a $15.20 cost basis), we will make 253% (the sale at $45.00 the additional $8.80 I collected along the way on the original purchase price of $15.20).

I hope that this help you. If you are interested in learning more, or actually making money on this strategy, try my option trading service at www.thrtrendrider.com the next time we open it to new members. I hope to see you there, and if not, I will talk to you in my next Tycoon Report article next Thursday.


“Profit from the Trend”

Chris Rowe
Chief Investment Officer
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