Why Puts are Better Than Calls for Calendar Spreads
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When you think of calls, you think about hoping the stock will go up. When you think of puts, you think about hoping the stock will go down. Those thoughts are appropriate when you are buying options. But they most certainly are wrong when you are buying calendar spreads.
When buying calendar spreads (also called time spreads), the strike price tells you which way you want the stock to go, not the choice of puts or calls. You always want the stock to move toward the strike price of your calendar spreads. That is where the maximum gain will take place, regardless of whether you own puts or calls.
There are two reasons why puts are a better choice than calls for calendar spreads:
1) The premium decay difference (the difference between the decay of the long-term options you own and the short-term options you have sold) is essentially the same for put and call spreads.
2) The put spreads cost less (usually in the neighborhood of 25% less) than the call spreads at the same strike price.
In the graphs below, I have compared the risk profile of a typical 10K Strategy using puts, and the same calendar spreads using calls. Below are the risk profile charts for 10 calendar spreads (Jun06 – Jan06) for Sears Holdings (SHLD) at the 110, 120, and 130 strikes (at a time when SHLD was trading about $119 in mid- December 2005). Note the essentially identical curves. It truly does not matter whether you are trading in puts or calls from a payoff basis at each possible stock price.
Since puts and calls are opposites, our intuition would tell us that the options could not possibly achieve nearly identical returns if you used either puts or calls. But calendar spreads are entirely different than only buying the options.
However, there is a major advantage to picking puts over calls. These 30 spreads would have cost $24,500 to buy with calls, and only $18,650 with puts. Both charts show a maximum profit of about $10,000 if the stock closes exactly at $120 on January 20, 2006, yet the put spreads cost 24% less to place, so the ROI for the puts would be 54% (at the maximum possible) compared to 41% if calls were used instead.
When you buy calendar spreads, you should purchase them at the strike price where you think the stock is headed. If you are bullish about the stock, you buy calendar spreads at a strike prices that are higher than the stock price. If you are bearish on a stock, you buy calendar spreads at strike prices that are lower than the stock price. In the 10K Strategy, we buy calendar spreads that are above, below, and at the stock price to give us protection in both directions – we are not tied to the stock moving in only one direction.
This little report should be worth thousands of dollars every year for active traders of calendar spreads. Just remember, when you are buying calendar
spreads, choose puts rather than calls, regardless of which way you think the stock is headed.