A calendar spread is an income trade that involves selling a short-term option and buying a longer-term option with the same strike price. Usually this is done with monthly options, but weekly options work too. Let's look at how to set up a calendar spread with McDonald's stock.
Calendar Spread On McDonald's Stock
McDonald's has been in a trading range since November. According to the IBD Stock Checkup, MCD stock ranks No. 21 in its group and has a Composite Rating of 78, an EPS Rating of 73 and a Relative Strength Rating of 81.
Yesterday, McDonald's stock traded around 264 and a calendar spread could use a strike price of 265 to set up a neutral outlook. Remember, for the calendar spread the strike price for both legs will be the same but the expiration dates will be different.
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Selling the McDonald's stock March 31 call at 265 brought in around $445 in premium yesterday. The 265 call a little further out with an April 14 expiration cost roughly $595.
That resulted in a net cost for the trade of $150 per spread. This is also the most the trade can lose.
Traders typically use call options unless the trade has a bearish bias. Then you can use the same principles but with puts.
Implied Volatility Changes The Math
As mentioned, the maximum loss is the amount paid of $150. The maximum profit is a little trickier. It varies based on changes to implied volatility but the estimate is around $300 for this trade. That's offers a double on the amount at risk.
The idea with the trade is that if McDonald's stock remains around 265 for the next few weeks, the sold option will decay at a faster rate than the bought option. This helps make a profitable trade.
The break-even prices for the trade are roughly around 256 and 277 for McDonald's stock price. But, like the profit levels, these can also change slightly depending on the impact of changes in implied volatility.
Managing The Trade
Since implied volatility changes make such an impact on how the trade performs, calendar spreads are more of an advanced strategy and not recommended for beginners.
For a trade like this I would set a profit target of 25%. The stop loss can use McDonald's stock price. If it breaks through either 256 or 277 it might suggest the trade isn't working as expected.
It's also important to keep the position size limited. In this case, I wouldn't risk more than 2% to 3% of my capital.
Please remember that options are risky, and investors can lose 100% of their investment.
This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ
