Covered Calls vs Calendar Spreads

Which is the Better Option Strategy
and How to Choose?

Covered calls and option calendar spread trades are structurally very similar option income strategies.

Understanding one helps you to understand - and gain insights - into the other, which in turn can help you determine which is the better option trading strategy for you.

Covered Calls and Calendar Spreads - Definitions

First, a couple of brief definitions.

It's likely that you're already familiar with the covered call option strategy - owning shares in a stock (in blocks of 100) and then selling someone else the opportunity to buy those shares from you at a set price in exchange for an upfront cash payment called premium.

Calendar spreads often go by a couple of alternative names - horizontal spread and diagonal spread - depending on where the strike prices get set, but I tend to use the term calendar spread almost exclusively regardless.

The important thing is to understand what a calendar spread does and how it works.

Basically, you're buying a longer dated call option and selling or writing a near term call against that long call.

The trade is actually identical to a covered call except that the long (and long dated) call acts as a proxy of sorts for actually owning the underlying shares.

Calendar spreads can be constructed using really longer dated options like LEAPS where the expiration date may be anywhere from a year up to 2 1/2 years away.

Or they may be constructed using long calls with a more intermediate expiration date - such as 6-9 months away.

Advantages of Calendar Spreads over Covered Calls

The whole premise or rationale for calendar spreads is that the trade exploits the difference between the time decay rates between longer dated options and near term options.

It's one of the defining features of stock options - the closer you get to an option's expiration, the faster that option's time value erodes.

So, yes, with a calendar spread you're purchasing a wasting asset (a long dated call). But you're also writing or selling another near dated option that's also wasting - and at a much faster rate. And, hopefully, you will be able to continue writing a new near term call each month, exploiting those time decay rates many times over.

The advantage of the calendar spread position over a covered call then is two-fold - and actually, these two advantages are two sides of the same coin:

The first advantage is that the calendar spread costs a whole lot less to set up than a comparable covered call.
What that cost difference turns out to be will vary - it depends a great deal on the strike price you select for your longer dated call, and how long until that option expires.
Even deep in the money call LEAPS will be a lot cheaper than buying a corresponding number of actual shares.
The second advantage is a direct result of the first - because your capital requirements are so much less, your potential profits are dramatically higher.
Think of how much better your returns would be on a ROI basis if your calendar spread only cost you a third of what it would cost to set up a comparable covered call position.
Or, how much in terms of TOTAL returns if you could afford to set up 3 times as many positions as you could as a traditional call writer.

Advantages of Covered Calls over Calendar Spreads

Sounds awesome, right? So let's all switch from covered calls to horizontal and diagonal spreads.

Not so quick - there are also advantages associated with covered calls.

In general terms, the biggest advantage is that covered calls expose you to much less risk.

It's not that calendar spreads are inherently high risk - much of the risk is determined by the quality of the underlying stock, the strike prices you choose, and finding the sweet spot between too volatile and not volatile enough - but when you write covered calls there are certain things you never have to worry about or consider:

The first thing you never have to deal with is when your underlying shares will expire. Unlike your LEAPS call, for instance, as long as the company remains solvent and publicly traded, they'll never expire. If you're going to write calls on them, you only have to buy them once.
The second thing you never have to worry about is the share price trading below the strike price on your long dated calls. If you purchase a $25 LEAPS call on a $35 stock and the shares end up trading below $25 at the time your LEAPS expire, those LEAPS will expire completely worthless.
At least when you own the shares, the only way you'll ever lose the entire amount of your original invested capital is if the shares trade down to zero.
And third, covered calls are a lot simpler to understand and track. It's not that calendar spreads are actually complicated (they're not, I promise) but there are a few more moving parts involved.
In particular, the net delta position or net delta value of your entire position is something you'll want to keep an eye on. Basically, the price movement of your long options and that of your short options most likely will not move at the same rate as the underlying shares when they move in price.

Again, this is not particularly complicated stuff, but it is a step up from covered call writing.

Covered Calls and Calendar Spreads - Choosing the Option Strategy That's Best for You

In the end, whether you choose to write covered calls or whether you choose to go with calendar or time spreads, that choice will probably be a combination of your own personality and preferences on one hand, and market conditions or opportunities on the other.

Incorporating covered calls on a long term stock portfolio in order to generate additional income (ala the Leveraged Investing way) may work best when the market (or your stock) is fully valued, or during bear markets, since the presumption is you don't want to sell your long term, income producing investments just because the Mr. Market is in a funk.

Likewise, calendar spreads work best when you feel very confident that a stock will be trading no lower at the end of the holding period (of your long dated calls) than it is when you initiated the trade.

I refer to calendar spreads as covered calls on steroids, and you can make tremendous returns for what I still consider to be pretty limited risk (providing you're very selective on the set ups), but if the stock really trades down, you may not have the opportunity to weather the storm as you might choose to do with a covered call position.

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