Rolling and Earning a “Free” Call
Many traders who trade income-generating strategies are conservative.
They are happy to sell low IV for the benefits afforded by low realized
volatility. This is the problem-avoidance philosophy of trading. Due to risk
aversion, it’s common to trade calendar spreads by buying the two-month
option and selling the one-month option. This can allow traders to avoid
buying the calendar in earnings months, and it also means a shorter time
horizon, signifying less time for something unwanted to happen.
But there’s another school of thought among time-spread traders. There
are some traders who prefer to buy a longer-term option—six months to a
year—while selling a one-month option. Why? Because month after month,
the trader can roll the short option to the next month. This is a simple tactic
that is used by market makers and other professional traders as well as
savvy retail traders. Here’s how it works.
XYZ stock is trading at $60 per share. A trader has a neutral outlook over
the next six months and decides to buy a calendar. Assuming that July has
29 days until expiration and December has 180, the trader will take the
following position:
The initial debit here is 2.55. The goal is basically the same as for any
time spread: collect theta without negative gamma spoiling the party. There
is another goal in these trades as well: to roll the spread.
At the end of month one, if the best-case scenario occurs and XYZ is
sitting at $60 at July expiration, the July 60 call expires. The December 60
call will then be worth 3.60, assuming all else is held constant. The positive
theta of the short July call gives full benefits as the option goes from 1.45 to
zero. The lower negative theta of the December call doesn’t bite into profits
quite as much as the theta of a short-term call would.
The profit after month one is 1.05. Profit is derived from the December
call, worth 3.60 at July expiry, minus the 2.55 initial spread debit. This
works out to about a 41 percent return. The profit is hardly as good as it