Method #3 - Calendar Spread Trading
This type of trading strategy can go by many names - calendar spread, horizontal spread, diagonal spread, time spread, covered calls with LEAPS, Bull Call LEAPS, etc.
But the core principle of this approach remains the same - capitalizing on the fact that an option's time value decays at a substantially higher rate on short term options than it does on long term options.
That's a relatively simple and straightforward statement, but the implications are profound.
Of course, the underlying stock's behavior does have an impact on the potential success and logistics of this type of strategy (the more volatile and erratic the stock is, the more difficult the trade becomes to manage), but keep in mind that you profit not by any specific movement of the stock per se, but rather on the passage of time itself.
If you're new to calendar spreads, the trade may seem a little complicated at first. But if you can remember the "spread" nature of the trade, it becomes much simpler to grasp.
In effect, you're buying a spread between an option's near term time value vs. an option's long term time value.
As expiration (for the short term option) nears and arrives, and all else being equal, the short term option will rapidly lose time value. As a result, your spread - and therefore your gains - will expand.
Examples
The calendar spreads themselves can take various forms. You can go the LEAPS route and buy call options that expire in, say, 24 months and write near term call options against them each month (similar to writing covered calls).
Here's a really simplistic example: If you buy a LEAP option expiring in 24 months with $10 of time value on it, and you're able to successfully write $1 calls against it each month, by the time you LEAP has run out of its own time value, it will have generated $24 in income, enough to have paid for the original LEAP as well as an additional 100%+ profit for your trouble (or rather, for your time).
Or you could go another route and set up a calendar spread with a much smaller window. You could buy a call option that expires in just three or four months and sell one at the same strike price expiring in one month.
There will still be more than enough difference in the rate of time decay (called theta) between the two options to make a solidly profitable trade. The advantages are a much shorter holding period and that you avoid the severe bid-ask spread penalty sometimes associated with LEAPS.
Pros, Cons, and Additional Resources
Calendar spread trading is not actually investing (unless you're using the strategy to fund the acquisition of actual stock), but there's such an inherent structural advantage to this type of trade, that, in many instances, considering risk-reward profiles, and depending on what precautions you take, I actually find it to be safer than how most passive investors approach investing - blind buy and hold or blind index or blind mutual fund investing.
But that's not to say that calendar spreads are ever without risk.
On the contrary, if you're not careful or if you're unaware of how to protect yourself, your portfolio can take a pretty good whack if an underlying stock makes a big move, even to the upside.
The good news, however, is that there are strategies and practices you can adopt to really stack the odds in your favor. If you want to learn more about this type of trading, you might want to consider Dr. Terry Allen's Stock Option Success service.
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