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Options 101: How to Win Big on Toll Brothers (NYSE: TOL) with a Calendar Spread

By , Contributing Writer, Money Morning •

Last week, I explained how to profit from housing-sector stocks like Home Depot Inc. (NYSE: HD) using a modified option straddle.

Today, we'll look at an alternative options strategy - known as a long-term calendar spread.

This strategy is better suited to stable or trending stocks.

It's particularly appropriate for companies, whose share prices aren't likely to make a major move until the housing recovery picks up more steam.

In this case, I'm talking about a company like the Toll Brothers Inc. (NYSE: TOL).

The key for using a calendar spread strategy on Toll Brothers is the prospect of a slow-appreciation scenario. That's likely, given the news in the housing market isn't always so rosy.

For example, MSNBC reported on Saturday that, in spite of the lowest rates ever and home prices that are down by a third since 2006, mortgages now are much harder to get.

That type of news is the primary reason you probably don't want to buy a stock like Toll Brothers right -especially since it's already up 74% off the October lows.

However, that doesn't mean you can't profit from Toll Brothers using options to create a long-term calendar spread.

How to Structure a Toll Brothers Calendar Spread

Here's how it might be structured, based on prices available early this week:

  1. With Toll Brothers trading at $22.16 a share, you would BUY three long-term January 2013 call options with a slightly in-the-money strike price of $22, quoted at $3.40 per share. That means each call, which represents 100 shares of TOL stock, would cost $340 - and the cost for three would total $1,020. These options are technically known as LEAPS, but they're priced the same as regular options and trade quite actively.
  2. Simultaneously, you would SELL (or write) three shorter-term March 2012 Toll Brothers call options with an out-of-the-money strike price of $23 a share, quoted this week at 85 cents a share - meaning selling three 100-share contracts would bring in $255 (minus a modest commission).

The resulting position is called a calendar spread because the two legs spread over different time periods. The opening cost the spread is $765.

So, what happens next?...

  • If Toll Brothers stock falls or stays roughly the same between now and March 16, you'll lose a little bit of intrinsic (real) and time value on your long January 2013 calls, but the March 23 calls will expire worthless, letting you keep the entire $255 received to offset the loss on your longer-term options.
  • If the stock rises, but still stays below $23 a share, you'll gain some intrinsic value on your long calls, but the March 23 calls will still expire worthless, and you keep the $255.
  • If the stock rises above $23 a share, the March $23 calls you sold will lose all their time value, but you'll have to buy them back because they'll be in the money and therefore have real value.

However, the price of your long-term January 2013 calls will also rise, giving you a paper gain to offset the cost of buying back the short-term calls.

Regardless of which of those three outcomes occurs, you immediately repeat the process, selling three out-of-the-money Toll Brothers calls with a June expiration date (the next month in TOL's so-called regular "option cycle").

The strike price of the option you sell will be determined by the price of Toll Brothers stock at the time, but it must be equal to or higher than the $22 strike price of the long January 2013 options you hold.
Otherwise, you'll have to put up a margin deposit to cover the difference between the strike prices.

The sale of the June options further reduces the cost of your long-term position, but the three possible outcomes are the same. And, once again, when the June options expire on June 15, you immediately re-establish the full calendar position using the September Toll Brothers calls.

Ditto when those expire, using the December options.

Once the December options expire, you can either sell your long January 22 call position, taking your profits, or you can sell a then short-term January call with a higher out-of-the-money strike price and pick up a few more dollars of time value on your trade.

It Sounds Complicated-But It's Not

The accompanying table shows how this series of trades might progress, assuming Toll Brothers moves in a slow upward trend as housing market conditions continue to improve over the coming year.

Toll Brothers

As you can see, the cumulative profit on the position rises steadily throughout the course of the trade even though four of the five options you sold had to be repurchased.

That's because the time value erodes far faster on short-term options than on the longer-term January 2013 calls, regardless of what the underlying stock does.

Note, as well, that the total profit of $1,026 on the series of trades represents a return of 134.1% on the original net cost of $765 - in just under a year.

On the flip side, had you bought 300 shares of Toll Brothers stock, your gain of $1,182 ($26.10 - $22.16 = $3.94 x 300 = $1,182), while slightly higher than on the calendar spreads, would have represented a return on the original cost ($6,648) of just 17.7% - and your dollar risk would have been far higher.

Finally, had you tried to play Toll Brothers by simply purchasing a series of short-term out-of-the-money calls, you would have lost money in every instance.

Of course, this calendar spread strategy will work with any stock in any sector, as long as stable or gradually upward trending price movements are expected.

Next week, I'll discuss how to generate income by selling cash-secured puts.

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