Calendar Spreads

Hello Mr Wolfinger,

I told a broker friend of mine that I wanted to buy 100 shares of CAT at $59.00 or $5,900 (rounding numbers for ease) since I think it will go higher
and I plan to keep it for a while, but he suggested the following instead.

To sell a May10 $57.50 Call for $4.25 and buy a Jan11 $40.00 Call for $19.50 creating a "debit" of $15.25.I "feel" the stock will continue to slowly go higher in the
coming months. Therefore this most certainly means I'm getting called on the May $57.50. If the stock closes at $63.00 at expiration date, I would have to pay $6,300 which
is really $5,875 since I received $425 in premium so it seems that I would have "lost" $125 (not counting commissions) and better off paying the $59 to begin with, since anything over $61.75 is not covered by the premium received.

OK, but then I also have the 1 Jan11 40.00 Call which I paid $19.50. Is there a way to figure out with some certainty how much this stock will be worth in May when the stock is at $63.00?

It seems this strategy would work best if the stock price stays above $57.50 but no more than $61.75 for the May 57.50 call and then the stock stays over $59.50 for the Jan11 40
call. Does this trade make sense?

Thanks for your help.


1) When your friend suggested the trade, it was his responsibility to explain what you had to gain or lose.

2) Yes there is a way to make a reasonable estimate of the value of your position at May expiration when the stock is $63.  But with 'some certainly' - no.  Cannot do that.  Why?  The value of an option is quite dependent on the implied volatility (IV) of that option.  The more time in the life of the option, the larger the effect of IV.  There is just no good way to know what it will be in May.  In Nov 2008, VIX (IV of S&P 500 index options) was 90.  Today it is 17. 

3) If you use an option calculator and try some various IV levels, you will get a decent of idea of where your Jan call will be trading.  But it's just an idea.  Try this calculator, although your broker ought to have one for you to use.

4) That said, this is a really dumb idea for you.  It's not a bad play in and of itself.  But you are looking for the stock to rise.  You want the chance to earn more money than this spread allows. 

5) I love the idea of buying the Jan 40 call @ only $0.50 time premium over the price of the stock.  That way you don't have to spend the $5,900.  You spend only $1,950.  Interest rates are low, but you can earn some interest with the other $4,000. 

6) If you are truly bullish, do you want to write a covered call, or is that merely the suggestion of your friend?   I love writing covered calls and like the idea in this situation.  But if you are bullish do you want to do that?  Perhaps a call with a higher strike price would be more suitable.  Perhaps waiting for the stock to  move higher and then sell the call would work.

7) If you are thinking of buying back the stock at May expiration, then it truly makes zero sense to sell a call option hat is already in the money.

Again he did suggest the right call to buy.  Give him credit for that.  But by failing to explain the whole trade idea, he did no service.  I don't know which call you should sell - because I don't know how much faith you have in your prediction.  Nor do I know how much risk you are willing to take.  But definitely begin with that Jan call - if you can get it for only $0.50 over parity.


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