Bracket Trading Techniques

Calendar spreads are also known as time or horizontal spreads because they involve options with different expiration months. In this case, "horizontal" refers to the fact that option months were originally listed on the board at the exchange from left to right. At the same time, strike prices were listed from top to bottom. For this reason, options with different strike prices and the same expiration are often referred to as vertical spreads.

In simplest terms, a long calendar spread involves buying an option with a longer expiration and selling an option with the same strike price and a shorter expiration. For example, imagine that Bubba Gump's (XYZ) is trading for $45 per share. To initiate a calendar spread, you might sell the Bubba Gump June 45 calls and buy the July 45 calls.

	June	July
XYZ 45 Calls	4.50	6.50
Time to Expiration	2 months	3 months

Spread Value: $2 (6.50 - 4.50)

Like most long positions, there is a cost to put on this trade. In this case, the cost is $2. For the time spread to work, the June option must lose its time premium faster than the July option. If the stock price remains relatively stable as the June expiration approaches, the value of the spread should increase. With only one month remaining before the June expiration, the option prices might look like this.

	June	July
XYZ 45 Calls	1.50	4.50
Time to Expiration	1 months	2 months

Spread Value: $3 (4.50 - 1.50)

In this case, the position could be closed for a one-point profit by selling the July calls and buying back the June calls.

For long calendar spreads to work, the underlying stock price must remain relatively stable. Any swings in either direction will negatively impact the time value of both options causing the spread to lose value.

Short Calendar Spreads

Example	Increase in Volatility	Time Erosion
Buy Near Term Position Sell Far Term Position	hurts position	helps position

A short calendar spread involves selling an option with a longer expiration and buying an option with the same strike price and a shorter expiration. For example, imagine that Bubba Gump's (XYZ) was trading for $45 per share. To initiate a short calendar spread, you might buy the Bubba Gump June 45 calls and sell the July 45 calls.

	June	July
XYZ 45 Calls	4.50	6.50
Time to Expiration	2 months	3 months

Spread Value: $2 (6.50 - 4.50)

Like all short positions, you receive a credit for putting on this trade. In this case, you receive $2 ($200). For this spread to work, the stock must move enough in either direction to cause both options to rapidly lose their time value. For example, if the stock dropped to $25, the spread might only be worth five cents.

	June	July
XYZ 45 Calls	0.05	0.10
Time to Expiration	1 months	2 months

Spread Value: $0.05 (0.10 - 0.50)

In this case, you could close the position by buying the spread for .5 and earning a 1.95 profit less commission. On the other hand, if the stock climbed to $65, the spread value might still decrease as time value is often less for in-the-money options.

	June	July
XYZ 45 Calls	21.50	22.25
Time to Expiration	1 months	2 months

Spread Value: $0.75 (22.25 - 21.50)

In this case, you could buy the spread for .75 to close out your position at a 1.25-point profit ($2 - .75) less commission. For short calendar spreads to work, the underlying stock price must make a significant move in either direction. Otherwise, lack of market movement will cause the spread to become unprofitable if the option with the earlier expiration loses time value at a faster rate than the other option.