A calendar spread, also called a horizontal spread or time spread, is the simultaneous sale and purchase of a call contract or a put contract with the same underlying security and strike price but different expirations. Typically, the sale is done in the nearby month and the buy is the longer expiration. If this is reversed, it is not surprisingly called a reverse calendar spread.
This strategy is employed for different reasons, but primarily to take advantage of a difference in Implied Volatilities (IV) between the expiration months. Specifically, the short contract has a higher IV than the long contract. In some cases, the IV difference can be so significant that the trade can be touted as a no-lose situation, which of course, is NEVER the case unless the net debit on the trade is $0. When you encounter this scenario and there is volume, please call me immediately before anyone else.
With that background, I have read some articles by others with their use of this strategy on Google (NASDAQ:GOOG), First Solar (NASDAQ:FSLR) and several others. I identified Intuitive Surgical (NASDAQ:ISRG) as my candidate using Calls while in the low 500's based upon my outlook for the stock. As a matter of fact, on October 4, 2012, I sold the ISRG October 530 Calls and bought the November 530 Calls. The net debit per spread contract was $4.20 with the October Call IV at 42.5% and November Call IV at 31.6%. I am neutral to slightly bullish on ISRG as well as the overall market environment, but earnings are being released after the close on October 16. In anticipation of that news, I expect that the IV's will increase until the earnings news release and then drop significantly immediately after the event.
I previously mentioned that no trade is a no-lose situation, so let's run through the possibilities with ISRG. ISRG reports disappointing earnings on October 16, the stock drops below $500 and does not rebound above $530 prior to the October expiration. I will keep the premium received for the October calls but I am still long the November Calls with a cost basis of $4.20 per contract. What will the contract values be with 4 weeks until expiration and using an IV at 37% (the mid-point between 42.5% and 31.6%), at 27% and at 22%, which is closer to the historical low volatility? See the table below for those expected values and keep in mind that my contract cost is $4.20.
If the opposite occurs and ISRG spikes above the $530 strike price, I will cover the October Calls at a loss that should be offset by the gain in the November Calls, now in the money, in addition to the time premium value for the 4 remaining weeks. Based upon the table below, one can see how this can be a highly profitable trade or a possibly a losing one.
ISRG November 530 CALL Price on October 19 with 28 Days to Expiration
ISRG Market PRICE
Expected CALL Price with 37% IV
Expected CALL Price with 27% IV
Expected CALL Price with 22% IV
The profit/loss will be determined by both the price of ISRG as well as the IV on October 19 and until the November expiration. The street has one Sell, 7 Holds, 3 Buys and 3 Strong Buys on the stock. Standard & Poor's analyst, Philip Seligman, has had a very good track record with his ratings and he currently has a Hold with a $598 target. Does the risk-reward scenario validate the trade? Based upon aforementioned, the fundamentals, and a technical analysis of ISRG, I assert that the trade is very justifiable, but an earnings surprise on October 16 could be the 'wrench in the works' for this trade, so stay alert.
Disclosure: I am long ISRG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: As stated in the article, I have a Calendar Spread on ISRG.