The basic goal of a calendar spread (also called a horizontal spread) is to sell a near-term option to collect premium in order to lower the cost basis of a longer-term option with the same strike price. The calendar spread can done with either calls or puts. The basic concept for this trade to be profitable is that the near-term option will lose all of its time value while the longer-term option retains a significant portion of its time value. Unfortunately, the profitability of this strategy also requires the price of the underlying stock to be sufficiently close to the common strike price as the near-term option reaches its expiration date.
In the traditional version of the calendar spread, a front-month option is sold against a more distant monthly option with the same strike price. Holding this version of the trade for several weeks while waiting for the front-month option to lose its time value can become very frustrating as you watch the price of the underlying stock drift far from the common strike price into a range that is likely to produce a loss at expiration.
Now that weekly options have become available on many stocks (and ETF's), there are new opportunities for the calendar spread trader. It is no longer necessary for the near-term option in a calendar spread to be the front-month option. The short, near-term options could be a weekly option that expires in nine days or less. While a smaller premium is received from selling a weekly option, there are some compensating features that make this new version of a calendar spread worthy of consideration.
By selling a weekly option, the opportunity to exit the trade arrives much sooner. When all of the time value in the weekly option has quickly decayed to zero, very little time value will have been lost in the long-term option. This offers the possibility of a quick exit for a profit that might be small, but also frees up capital to move on to a new trade.
Even though a smaller premium is received from selling the weekly option, the possibility of repeating the process over 3-4 weeks could easily provide a total premium in excess of that received from the one-time selling of a front-month option. Here again there is the opportunity to close the trade at the end of any week in which it appears unwise to continue holding the long position.
With a weekly option as the near-term component in the calendar spread, it becomes easier to convert the calendar spread into a diagonal spread. As one weekly option expires, it may be advantageous to roll into a new weekly option with a strike price that is further out-of-the-money. This might open up the opportunity for a bigger long-term profit if the price of the underlying stock keeps moving in a direction that favors the long-term option.
To illustrate this concept of using weekly options to create a diagonal spread, let's consider a trade that was issued earlier this week. The recommendation on Tuesday (9/18) was to buy the October 32 calls (expiring 10/19) on the iShares Silver Trust (SLV). The average entry price was $1.96 per share. To convert the position of long calls into a diagonal spread, it was suggested today (9/20) to sell an equal number of contracts of the weekly September 34.50 calls (expiring 9/28) at a price of $0.25 per share. This creates a diagonal spread trade that is long the October 32 calls and short the weekly September 34.50 calls. By selling the weekly calls, the cost basis of the long calls has been reduced to $1.71 per share [1.96 - .25 = 1.71].
Let's examine the possible outcomes for the diagonal spread at the expiration date of the weekly calls next Friday (9/28). If the price of SLV is below $34.50, the weekly options will expire worthless and the October 32 calls can be held for future gains with a substantially reduced cost basis. If SLV is above $34.50, the diagonal spread can be closed by buying back the September 34.50 calls while simultaneously selling the October 32 calls for a profit of about $0.85 per share or better. That represents a nice return of almost 50% in less than two weeks.
There are currently well over 100 stocks and ETFs that trade weekly options. Popular stocks that have weekly options include Apple (AAPL), Amazon (AMZN), Facebook (FB), Google (GOOG), Qualcomm (QCOM) and Yahoo (YHOO). There are several heavily traded index ETFs with weekly options as well. Your broker should be able to provide a complete list.
Additional disclosure: Olmstead Options recommended an options play using SLV October 32 calls earlier this week.