"October: This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February." Mark Twain
My unscientific survey of articles on Seeking Alpha would rate Apple (AAPL) one of the most often discussed stocks and Calendar Spreads one of the least talked about Option Strategies. So I thought it would be an interesting idea to combine the "most-est with the least-est" and see what we could learn and walk away with.
Most option strategies, such as buying/selling calls/puts and call/put spreads can be seen as directional strategies. That is, they hope for price movement in a particular direction to make, or maximize profit.
Calendar Spreads, on the other hand, are MAGNITUDE strategies. That is, they make profits if the underlying moves, but not too much. Even of you guess the direction right, you can lose if the underlying stock overshoots by too much. However, if you guess the direction wrong, you can still profit as long as you didn't miss by too much. Thus, Calendar Spreads must be viewed most properly as a hedged play, rather than an outright play.
As such, making specific Calendar Spread recommendations must be analyzed carefully, as they are more a TOOL rather than a TRADE. So let's explore this tool and how it can apply to a stock like AAPL.
Calendar Spreads consists of two legs .... 1) Selling a near term option and 2) Buying a far-dated option... either both calls or both puts.
Because the two legs, when taken together, represent "opposite positions" (one long, one short) they move in opposite directions. This is easiest to understand by exploring an ATM Calendar Call Spread.
With AAPL currently trading at $629.71, the November $630 call can be sold for a credit of $ 26.50, while the February 2013 call can be purchased for a debit of $48. Let's look at possible outcomes:
1) AAPL closes in November, unchanged, at $630: BEST scenario, you make the full $26.50 November credit and lose only time decay (Theta) on the February call. Most option software provides Theta as a per/day amount. The AAPL Feb. 2013 call Theta is estimated at $6.50 cumulative through November expiry. Therefore, the net profit would be the credit of $26.50 less the Theta loss of $6.45, or about $20.
2) AAPL moves up: As AAPL starts moving up you "give back" on the November call but gain on the February call. The "give back" is 100%, whereas you gain about 50% (the Delta of the February call). The more AAPL moves up, the more Delta increases, so your "give back" reduces as AAPL climbs. Hint: When using ATM Calendar Spreads, consider that your net change is approximately 50% of the move.
Let's say AAPL moves up to $656.50, so that you "give back" the full $26.50 call credit and break even on that leg. Well, the February call would have moved up around $13-$14 (after Delta increase and theta decrease) and that represents your net profit. If AAPL moves up less than $26, your profit is somewhere between the "unchanged profit" of $20 and the $656 profit of $13-$14.
Let's say AAPL moves up, above $656, so you lose 100% on the increase in the November short call, but gain about 60% on the February call. In the end, your break even is around AAPL=$690.
On the surface, that looks like a pretty big profit window. But, hey !!!!, AAPL just moved from $630 to $690 and YOU MADE NOTHING. Certainly not a Bull play.
3) AAPL moves down: This time you gain $26.50 on the November call credit, but "give back" on the February call. The "give back" starts at 50%. The $26.50 credit is 100% gain while the far-dated call gives back about 50% of the down move. So, if AAPL falls about $55 (9%) the far dated has given back all the gains from the $26.50 call credit. Below that, losses mount. Summarily, you make something unless AAPL falls below $575, so you have considerable downside protection.
So, what we see, is that an ATM Calendar spread maximizes profit if the underlying (in this case AAPL) closes unchanged. Gains then diminish as AAPL moves up/down and losses come in on a move up/down over about 9%.
Quite frankly, as an AAPL Bull, I wouldn't engage in an ATM Calendar Spread on AAPL. The recent price drop has me thinking of a considerable bounce as more likely than a considerable drop. I may be too optimistic, but that's my prerogative. Calendar Spreads offer many variations and I can try for a better match ... the Diagonal Calendar Spread.
The Diagonal Calendar Spread has the same two legs, a near term short option paired with a far-dated long option. The difference is that one, or both legs are OTM (technically they could be ITM, but in these instances it is more efficient to switch from a call spread to a put spread or vice-versa).
The challenge in a Diagonal is deciding just how much of a Bull I am (or Bear, if I want to use diagonal puts instead of calls). One approach is to simply pick a "gut number" such as $650. $675 and so on.
I think that the near-dated short call should be set with a strike at least sufficient to zero out the Theta loss on the far-dated long call, taken till the November expiry. It turns out that the November $690 call will credit $6.45 (almost exactly the expected Theta loss). So, the $690 strike seems to work perfectly as it also happens to be close to AAPL's all-time-high.
Since the $690 call matches the expected Theta loss, there is no real extra downside protection. Downside protection would require a lower strike, but that risks AAPL over-running the strike and losing where another strategy would gain.
So, it seems to me that a Diagonal on AAPL should be viewed only as a tool to offset Theta decay for those buying calls. Of course, if AAPL was nearer a high, then a Calendar could work as a protective tool.
Summary: Calendar Spreads are a type of hedged play on a stock. They work effectively if you get the direction and magnitude right. Standard ATM Calendar Spreads are not well suited for a stock that has dropped, such as AAPL has recently. The last thing anyone wants is for a massive run-up in the stock they chose and find out they lost money. On the other hand, Calendar Spreads can be used when a stock is nearer its high or Diagonals as a time-decay (Theta) offset.
It is my conclusion that Calendar Spreads are not as effective on a hi-beta stock such as AAPL as they might be on lower beta stocks like PG, JNJ, XOM or ETFs such as DIA and SPY. But, if you like to buy calls on a hi-beta stock such as AAPL, then the Diagonal could well work to your benefit by reducing Theta costs.
One last note: There are many other variations of calendar spreads that could be discussed. Additionally, when to use call spreads vs. put spreads is a whole subject unto itself. I hope readers will appreciate the limits imposed upon any one article in exploring all these variations. I hope to get to some of them in the future.
Additional disclosure: I buy and sell options on AAPL