Long Call Calendar Spread

Introduction

You have been researching a stock and have formed a neutral to moderately bearish or moderately bullish opinion on its value, forecasting that it will trade around a specific price for a period of time.

Building on your knowledge of call and put options as well as the risks and benefits of single-leg options trades (buy call, sell call, buy put, sell put), you recognize that a two-leg trade, or spread trade, might help achieve the objectives you have outlined.

Combining a long call and short call across different expiration months is referred to as a calendar spread trade. The risks and benefits of each individual option component, or leg, offset each other to a degree in order to create the desired position and range of possible outcomes.

You refine your trading goal and decide the calendar spread has the right risk-reward profile:

1) Generate profit if there is limited price movement around the strike price of the calendar spread and accept limited risk exposure to the upside or downside.

Alternatively, another goal might have made the calendar spread a reasonable choice as well:

2) Generate profit from a directional stock price move toward strike price of the calendar spread and accept limited risk if the market goes in the other direction.

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What is a Long Call Calendar Spread?

A long call calendar spread consists of one short call with a nearer-dated expiry and one long call with a longer-dated expiry:

§ Short 1 XYZ (Month 1) 100 call

§ Long 1 XYZ (Month 2) 100 call

Both calls have the same underlying stock and the same strike price.

Maximum profit and maximum risk (loss) are limited and known and the strategy is established for a net debit.

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Additional Considerations

A long call calendar spread realizes its maximum profit if the stock price equals the strike price on the expiration date of the short call. The forecast, therefore, can either be “neutral,” “modestly bullish,” or “modestly bearish,” depending on the relationship of the stock price to the strike price when the position is established:

• If the stock price is at or near the strike price when the position is established, then the forecast must be for unchanged, or neutral, price action.
• If the stock price is below the strike price when the position is established, then the forecast must be for the stock price to rise to the strike price at expiration (modestly bullish).
• If the stock price is above the strike price when the position is established, then the forecast must be for the stock price to fall to the strike price at expiration (modestly bearish).

Worth noting: The long call calendar spread is also referred to as a “long time spread” or a “long horizontal spread.” “Long” in the strategy name implies that the strategy is established for a net debit, or net cost. The terms “time” and “horizontal” describe the relationship between the expiration dates. “Time” implies that the options expire at different times, or on different dates. The term “horizontal” originated when options prices were listed in newspapers in a tabular format. Strike prices were listed vertically, and expirations were listed horizontally. Therefore, a “horizontal spread” involved options in the same row of the table; they had the same strike price, but they had different expiration dates.

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Example

Short 1 XYZ (Month 1) 100 call for $3.35

Long 1 XYZ (Month 2) 100 call for $4.75

In our example, assume stock XYZ is currently trading around $100.

We sell 1 XYZ (Month 1) 100 call for a total of $335 (1 x 100 multiplier x $3.35) and buy 1 XYZ (Month 2) 100 call for a total of $475 (1 x 100 multiplier x $4.75).

In this example the long call calendar spread (long call + short call) positions were established for a net debit of $140 (not including commissions and fees).

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Outcome 1: Profit

With a long call calendar spread position, potential profit is limited.

First, let’s recall the formulas for individual options positions:

For the Long Call,

if S - K < 0, then the Loss = Net Premium Paid

if S - K > 0, then the Profit = Current Stock Price – Strike Price – Net Premium Paid

For the Short Call,

if S – K > 0, then the Loss = – (Current Stock Price – Strike Price) + Net Premium Received

= – Current Stock Price + Strike Price + Net Premium Received

if S – K < 0, then the Profit = Net Premium Received

To calculate our profit on the position we established, we use the following formula:

Profit = Net Profit/Loss on Long Call + Net Profit/Loss on Short Call

The maximum profit of the long call calendar spread is realized if the stock price is equal to the strike price of the calls on the expiration date of the short call. This is the point of maximum profit because the long call has maximum time value when the stock price equals the strike price.

Since the short call expires worthless when the stock price equals the strike price at expiration, the difference in price between the two calls is at its greatest. Note, it is impossible to know for sure what the maximum profit will be, because the maximum profit depends of the price of the long call which can vary based on the level of volatility.

Example

Stock XYZ is trading at $100 and you establish a long call calendar spread position.

• Sell 1 XYZ (Month 1) 100 call for $3.35
• Buy 1 XYZ (Month 2) 100 call for $4.75

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*Profit or loss of the long call is based on its estimated value on the expiration date of the short call. This value was calculated using a standard Black-Scholes options pricing formula with the following assumptions: 28 days to Month 1 expiration, volatility of 30%, interest rate of 1%, and no dividend.

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Outcome 2: Loss

Let’s assume we are incorrect in our sentiment, and the stock price moves away from the long call calendar strike. To calculate our loss on the position, use the following formula:

Loss = Net Profit/Loss on Long Call + Net Profit/Loss on Short Call

Maximum loss is equal to the cost of establishing the spread position, including commissions and fees. If the stock price moves sharply away from the strike price, then the difference between the two calls approaches zero and the full amount paid for the spread is lost.

For example, if the stock price falls sharply, then the price of both calls approach zero for a net difference of zero. If the stock price rallies sharply so that both calls are deep in the money, then the prices of both calls approach parity for a net difference of zero.

In our example:

Max Loss = Total Net Premium Paid

= $1.40 per share or $140 total (not including commissions and fees)

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Outcome 3: Breakeven

There are two breakeven points, one above the strike price of the calendar spread and one below. The breakeven points are the stock prices on the expiration date of the short call at which the time value of the long call equals the original price of the calendar spread. Since the time value of the long call depends on the level of volatility, it is impossible to know for sure what the breakeven stock prices will be.

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At-A-Glance

Strategy

Long Call Calendar Spread

Alternative Name

Call Horizontal

Pre-Requisite Strategy Knowledge

Long Call

Short Call

Legs of Trade

2 legs

Sentiment

Neutral

Example

· Short 1 XYZ (Month 1) 100 call

· Long 1 XYZ (Month 2) 100 call

Max Potential Profit (GAIN)

Back month premium — front month premium — total net debit to establish position

Break-Even Point

See details above

Max Potential Risk (LOSS)

Total Net Premium Paid

Ideal Outcome

XYZ price trades at or near the strike at expiration

Early Assignment Risk

Early assignment risk applies to short options positions only.

Equity options in the United States can be exercised on any business day, and the holder of a short stock options position has no control over when they will be required to fulfill the obligation. Therefore, the risk of early assignment must be considered when entering positions involving short options. Early assignment of stock options is generally related to dividends.

The long call (longer-dated expiry) in a long call calendar spread has no risk of early assignment.

The short call (nearer-dated expiry) does have such risk.

If assignment for the short call is deemed likely and if a short stock position is not wanted, then appropriate action must be taken. Before assignment occurs, the risk of assignment can be eliminated in two ways:

• First, the entire spread can be closed by selling the long call to close and buying the short call to close.
• Alternatively, the short call can be purchased to close and the long call can be kept open.

If early assignment of the short call does occur, stock is sold, and a short stock position is created. If a short stock position is not wanted, there are two choices:

• First, the short stock position can be closed by exercising the long call.
• Second, shares can be purchased in the marketplace and the long call can be left open.

Generally, if there is time value in the long call, then it is preferable to purchase shares rather than to exercise the long call. It is preferable to purchase shares in this case because the time value will be lost if the call is exercised.

Note, whichever method is used to close the short stock position, the date of the stock purchase will be one day later than the date of the short sale. This difference will result in additional fees, including interest charges and commissions. Assignment of a short call might also trigger a margin call if there is not sufficient account equity to support the short stock position.

Potential Position Created at Expiration of the Short Call

If the short call is assigned, then stock is sold and a short stock position is created. In a long calendar spread with calls, the result is a two-part position consisting of short stock and the long call. This position has limited risk on the upside and substantial profit potential on the downside. If a trader has a bearish forecast, then this position can be maintained in the hopes that the forecast will be realized and a profit will be earned. If the short stock position is not wanted, then the position must be closed either by exercising the call or by purchasing stock and selling the call.

Charts

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