Executing A Bull Calendar Spread

Introduction To Bull Calendar Spread

Executing A Bull calendar spread

A bull calendar spread can be created by buying a long term  out of the money call option with the writing of a current month call option. Both call options have the same underlying security and the same strike(exercise) price.

The whole idea behind this strategy is to capitalise on a bullish outlook in the long term while paying a discounted price for the long call position. Writing calls allows the trader to collect premium.

Since the outlook is long term in nature, the options which have been shorted expire worthless first. Subsequently, if the price of the underlying security increases, the price of the long call will also increase.

Steps

Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Flat or slight decline over short term but bullish over long term
Step 3 : Study the option chain
Step 4 : Limited loss
Step 5 : Unlimited profit potential
Step 6 : Calculating potential loss, potential profit and risk & reward Ratio
Step 7 : Set Up Trade : Executing a bull calendar spread
Step 8 : Exit Trade
Step 9 : Record Trade In Diary

Step 1 : Perform economic, fundamental and technical analysis

The bull calendar spread is a complicated one as it involves options with different expiration dates. Hence, the trader must be able to look out for events that will cause the general markets to be bullish over the longer term, on an economic level, fundamental level and technical level. As for the near term, the trader must have reason to believe, due to the absence of these volatility triggering events, that the price of the underlying security is in slight decline or flat. Some chart patterns a trader should look out for is:

The trader should execute the trade before breakout. The idea is to execute the trade as prices fall so that the near term written option expires worthless. After the breakout, the longer term option increases in value.

Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis

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Step 2 : Outlook – Flat or slight decline over short term but bullish over long term

After the trader has performed economic analysis, fundamental and technical analysis, the trader should be convinced  that the price of the underlying security is flat and in slight decline for the near term but is bullish over the longer term. When underlying security prices stay stagnant or trade downwards slightly, the out of the money call options which were shorted expire worthless. Over the longer term, as the underlying security prices increase, the long call options increase in value.

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Step 3 :Study the option chain

Study the options chain available and examine the option premium of the options of different strike prices. Next, select the options to construct the bull calendar spread.

Read :  Learn to read and understand options chain

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Step 4 : Limited loss

The worse case scenario is this. Since  long term call options are bought and an equal number of near term call options at the same strike(exercise) price are shorted, the trader that executed this strategy receives a debit to his account. Why? That is because the long term call option is more expensive than the near term call option due to differences in time value. That initial debit is his maximum loss. Hence, there is a limited downside risk to this trade.

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Step 5 : Unlimited profit potential

Executing A Bull calendar spread

Despite the initial debit to the trader’s account, he still has a possibility of capturing the underlying security price moves to the upside. When the shorted options expire worthless and the price of the underlying security increases, the premium of the call option increases as well. Hence, this is a modification of the long call strategy. This means that his profit potential is unlimited.

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Step 6 : Calculating potential loss, potential profit and risk & reward Ratio

Calculate the potential loss and profit, keeping in mind the potential entry and exit prices. Next, calculate the potential risk, reward ratio to have an idea of the attractiveness of the trade. The risk reward ratio should be comparably better than past trades of the same nature or exactly similar or identical trades done in the past.

Read more : Understanding Risk/Reward Ratio For Option Traders

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Step 7 : Set Up Trade : Executing a bull calendar spread

  • Sell one near term out of the money call option
  • Buy one long term out of the money call option
  • The ratio of the number of long call contracts to the number of short call contract is 1 : 1 . That means that a trader could sell 10 out of the money call option contracts and sell 10 out of the money call option contracts

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Step 8 : Exit Trade

The ideal exit for a bull calendar spread is to let the near term option expire worthless. At this point, if the trader is still of the view that there is no catalyst to cause the price of the underlying security to increase significantly, then the trader can write another near term call option. This serves to reduce the cost of the position. However, if a catalyst is projected to occur soon enough, the trader should just hold onto the long call to profit from bullish movements of the underlying.

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Step 9 : Record Trade In Diary

Last but not least, record the trade  in a diary for analysis and comparison against other trades. This will help a trader become better over time.

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Example of a bull calendar spread

It is November 2015 and Starbucks Corp is trading at $62.15.

a bull calendar spread

The charts show a general uptrend over the past 1 year and analysts are bullish on the company. However, Starbucks is in a minor downtrend as can be seen on the charts. But 1.5 – 2 months months, you project that Starbucks could be trading at $70.

You believe that Starbucks will not trade above $63 in the current month and decide to short 1 call options contract with a strike(exercise) price of $63 expiring November for a premium of $55 and buy 1 call options contract with a strike(exercise) price of $63 expiring in December for a premium of $135.

A Strike

The option premium of the near term written call  at a strike(exercise) price of $63 is $55.

A strike

The option premium paid for a longer term call option contract with a strike(exercise) price of $63 is $135.

Your net cost(debit) for this trade is :

$135 – $55 = $85

Shorted out of the money options expire worthless

By the expiry date of the shorted calls, Starbucks trades at $61 and hence your written calls expire worthless. The whole idea of the trade is to allow the out of the money, near term, shorted calls to expire worthless and hence get a discounted price on the longer term call options.

Underlying security increases in price and so does value of long calls

By the expiry date of the December call options, the price of Starbucks has already risen to $70 and is now worth $700.

Total profit for the trade

Since a net debit of $85 was created when the trade was executed, the profit of the trade becomes: $700 – $85 = $615

What happens if Starbucks never trades above $63?

In a scenario where Starbucks never trades above $63, all the options that were bought and written will expire worthless.  The total loss to the trade is the $85 debit that was created when the trade was executed.

Advice

If you find the above example confusing, do not execute this trade unless you are a fairly seasoned veteran. Do trade with a virtual account and become familiar with the bull calendar spread strategy before executing it as a real trade.

Neutral calendar spread

If a trader is neutral on the underlying security, that is, he does not expect the underlying security price to move up or down, he can execute a neutral calendar spread by selling near month at the money calls to profit from time decay.

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