In the past, we discussed setting up calendar spreads using a LEAPS. The theory here is to leverage returns using less capital to fund the trade. This can be an effective strategy to add to your monthly trades for income. Today, we will discuss how to manage the calendar spread when prices changes.
For the LEAPS, when stock prices increase the value of the LEAPS will increase so it is a good thing for the trader. The problem arises when the stock prices rises above the strike price of the call we sold. When using LEAPS in spreads, you do not want to be called out or exercised. What can you do when stock price rises above the strike price?
You can purchase the short call by buying to close those options. Since the stock price is above the strike price, the extra intrinsic value of being ITM is priced into the short call. This usually means you will take a loss when you buy to close this option. However, the LEAPS will have gained value to more than offset the loss on the short call. This happens because the delta on the LEAPS will be higher than the delta on the short call. Then, you can sell a new call at a higher strike price against the LEAPS call to generate more income.
In comparison, what do you do when the stock price declines? One option is to close the position. In this case, you will make some money on the short call but take a bigger loss on the LEAPS that will result in a total lose on the trade. Another alternative is to roll down or roll out the short call keeping the LEAPS. To roll down, the trader would buy to close the short call and sell a new call at a lower strike price. This would lock in a profit on the short call because the stock price decreased and the new call sold will generate more income. To roll out, you would buy to close the short call, then sell a new call in the next month. This will increase the income from the short call sell since you have more time value in those calls.