December call go to zero, the position is still a profitable trade because of
the continued month-to-month rolling. This is now a no-lose situation.
When the long call of the spread has been paid for by rolling, there are
three choices moving forward: sell it, hold it, or continue writing calls
against it. If the trader’s opinion calls for the stock to decline, it’s logical to
sell the December call and take the residual value as profit. In this case,
over three months the trade will have produced 4.50 in premium from the
sale of three consecutive one-month calls, which is more than the initial
purchase price of the December call. At September expiration, the premium
that will be received for selling the December call is all profit, plus 0.50,
which is the aggregate premium minus the initial cost of the December call.
If the outlook is for the underlying to rise, it makes sense to hold the call.
Any appreciation in the value of the call resulting from delta gains as the
underlying moves higher is good—$0.50 plus whatever the call can be sold
for.
If the forecast is for XYZ to remain neutral, it’s logical to continue selling
the one-month call. Because the December call has been financed by the
aggregate short call premiums already, additional premiums earned by
writing calls are profit with “free” protection. As long as the short is closed
at its expiration, the risk of loss is eliminated.
This is the general nature of rolling calls in a calendar spread. It’s a
beautiful plan when it works! The problem is that it is incredibly unlikely
that the stock will stay right at $60 per share for five months. It’s almost
inevitable that it will move at some point. It’s like a game of Russian
roulette. At some point it’s going to be a losing proposition—you just don’t
know when. The benefit of rolling is that if the trade works out for a few
months in a row, the long call is paid for and the risk of loss is covered by
aggregate profits.
If we step outside this best-case theoretical world and consider what is
really happening on a day-to-day basis, we can gain insight on how to
manage this type of trade when things go wrong. Effectively, a long
calendar is a typical gamma/theta trade. Negative gamma hurts. Positive
theta helps.
If we knew which way the stock was going, we would simply buy or sell
stock to adjust to get long or short deltas. But, unfortunately, we don’t. Our