by Justin Kuepper on May 13, 2013 | Updated May 23, 2013 | ETFs Mentioned: GLD

Exchange-traded funds (“ETFs”) provide an easy way for investors to gain access to nearly any country or asset class. In addition to providing diversified exposure in a single U.S.-traded security, ETFs are equities themselves that may have options available to trade. These options open up the door for investors to create additional highly targeted strategies [see also ETF Call And Put Options Explained ].

In this article, we’ll look at the neutral calendar spread strategy and explore how ETF investors can use it to capitalize on sideways trading.

What Is a Neutral Calendar Spread Strategy?

Suppose an investor owns a commodity ETF that he or she uses to diversify an otherwise equity-heavy portfolio. Since the ETF is being used as a hedge, the investor may not be particularly bullish on the commodity ETF’s prospects. In this case, the investor could employ a neutral calendar spread in order to generate income from this sideways trading.

The investor would simply sell one near-term at-the-money call and buy one long-term at-the-money call option to create the neutral calendar spread. The resulting position takes advantage of the short-term option’s time decay, with the maximum losses limited to the debit taken to enter into the position, making it a relatively safe and predictable strategy [see Covered Call ETF Options Strategy Explained ].

The resulting option diagram look like this:

Who Is the Neutral Calendar Spread Strategy Right For?

The neutral calendar spread strategy is perfect for investors that have a neutral outlook on a given ETF. which can occur for a variety of different reasons. In the example above, the investor was holding the ETF as a hedge and may not be expecting it to rise or fall in the near-term. But, other examples could include any other ETF that lacks a catalyst or is trading sideways [see also How To Hedge With ETFs ].

The strategy works best in neutral markets, where the underlying stock price remains unchanged upon expiration of the near-term call option. The ideal market for this strategy would have very little in the way of near-term fundamental catalysts and would be exhibiting sideways trading patterns when using technical analysis (e.g. within a defined price channel).

What Are the Risks/Rewards?

The neutral calendar spread strategy has a very well defined risk to reward profile. Profit potential is limited to the premiums collected from the sale of the near-term call option minus any time decay of the long-term call option. Meanwhile, downside risks are limited to the initial debit taken to enter into the position, which goes into effect when the stock price declines [see also How To Take Profits And Cut Losses When Trading ETFs ].

The maximum profit and loss scenarios are:

• Maximum Profit occurs when the underlying stock remains unchanged upon expiration of the near-term month option.
• Maximum Loss occurs when the underlying stock falls and stays lower until expiration of the long-term month option.

How to Use a Neutral Calendar Spread Strategy

Suppose that an investor owns 100 shares of the SPDR Gold Trust ETF (GLD, A- ) and believes that it will trade sideways over the coming three months. So, he or she decides to use the neutral calendar spread strategy and sell/write one near-term at-the-money JUN 140 call for $4.83 and buy one long-term at-the-money AUG 140 call for $6.05 for a net debit of $122 to enter the position.

There are three basic scenarios that could then play out: