In the world of options trading, do you know how to set up a calendar spread?
This income-generating trade involves selling a short-term option and buying a longer-term option with the same strike price.
Usually you do this with monthly options, but it can also be done with weekly options. Traders typically use call options unless the trade has a bearish bias. In this case, they would use puts.
In today’s example, we’ll look at a calendar spread trade on Facebook (FB).
Facebook Stock: How A Calendar Spread Works
With Facebook stock closing Tuesday’s trading around 306, setting up a calendar spread at 310 gives the trade a neutral to slightly bullish outlook.
Ahead of Wednesday’s sharp market sell-off, selling the June 4 call option with a strike price of 310 would have generated around $750 in premium and buying the June 18 call at 310 would have cost around $980. That results in a net cost for the trade of $230 per spread. In other words, that is the most the trade can lose.
The estimated maximum profit is $500, but that could vary depending on changes in implied volatility.
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The idea with the trade is that if FB holds around 310 for the next few weeks, the sold option will decay at a faster rate than the bought option, allowing the trade to be closed for a profit.
The break-even prices for the trade are estimated at around 295 and 325. But these can also change slightly depending on the impact of changes in implied volatility.
For this reason, calendar spreads are considered a more advanced strategy and not recommended for beginners.
For a trade like this I would set a profit target of 25%. Plus, I would set a stop loss if Facebook stock breaks through either 295 or 325.
Always remember that options are risky and investors can lose 100% of their investment.
This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions. Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ
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