Calendar Spread Explained

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OAP 079: How To Trade Calendar Spreads – The Complete Guide

January 16, 2020

Today’s podcast is all about learning how to trade calendar spreads. And while newbie traders might find them a little difficult to understand conceptually at first, I think you’ll find our talk today to be incredibly helpful as we break down these time spreads from start to finish. During the show, I’ll walk through setting up and building calendar spreads, the impact of implied volatility and time decay, how to adjust and exit as well as the best market setups for these low IV option strategies.

Key Points from Today’s Show:

  • A calendar spread takes advantage of the pricing differential that may start to develop between a front month option and a back month option.
  • Most calendar spreads are set up to have a one-month differential.

Setting Up a Calendar Spread

  • To set up, first sell the front month option and then buy the same strike price and contract back month option for the next month. For example, you might sell the 50 strike puts in January, and then buy the 50 strike puts in February or March.
  • This takes advantage only in the difference in time between the two monthly contracts.
  • The key is to use the exact same strike price and the exact same type of option.
  • When scanning for great calendar spread trades, look for low IV rank like we found using our Watch List Software.

Price of a Calendar Spread

  • The price that you pay for a calendar spread is the difference between selling the front month and buying the back month contract.
  • This debit that you pay becomes your max loss at the first expiration date.

Example:

The USO ETF trades at $11.72. Looking at the January-February call calendar in USO, the January strike calls are trading for $16-$17. The exact same 12 strike calls in February are trading for $34-$36. To create a new call calendar spread for USO, sell January’s calls, collect a premium of $16-$17 and then buy the back-month calls — February calls. The next debit will be

$20. This is your max loss for the January expiration date.

Once you get to the January expiration, those February options may still have value that could be lost if you go past the January expiration. Therefore most calendars are managed in the front month expiration.

Calendar Spread Potential Profit

  • Potential profit is hard to peg on calendars because it depends on the difference between the strike prices as you get towards expiration.
  • Calendars are only concerned with extrinsic value in the different contract months — time value and volatility value.
  • Intrinsic value is always the same and directly offset from one contract to another because you are trading the exact same strike in opposite directions.
  • Maximum potential profit will be achieved if the stock lands at your strike price, at front month expiration.
  • The payoff diagram can expand or contract with volatility as you get closer to expiration. Example of simulated higher implied volatility is below.

When Are Calendars Best Used?

  • Calendar spreads can be used in any direction — bullish, bearish, or neutral around the stock.
  • Backtesting shows the best success comes when you are either slightly bullish or slightly bearish on the stock.
  • To balance your portfolio, can use a calendar spread to trade in the direction of where you need your portfolio to move.
  • Calendar spreads are best suited during periods of low to high volatility.
  • During periods of high volatility, option prices are going to expand and time decay will be less on the back month contracts that you are long.

Adjusting Calendar Spreads

  • Calendar spreads are usually very cheap positions that do not need as much adjustment.
  • If a trade is going in the opposite direction of where you think it is going to go, roll your short strike as the market is moving.
  • With a put calendar spread, if the stock price increases, roll up your puts to move in the direction of the market.
  • Another adjustment strategy is to add another position, creating a double calendar spread — not a preferred strategy.

Example:

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For the 12 strike call calendar spread for USO stock, if USO price falls, roll down the short 12 calls for a credit which helps reduce the cost of the calendar spread and transfers some of the risk, shifting your payoff diagram lower.

Exiting and Closing Out Calendar Spreads

  • Sell the back month option, buy back your front month option, and close the position for a higher price.
  • If you reach expiration and the stock has not moved as well as expected and your options are both out of the money, can let your front month option expire and keep the back month option as a lottery ticket for the next 30 days.

Example:

Assumed USO would move up to 12 strikes for call calendar, but USO stayed lower all the way through the expiration cycle. Will still get some benefit from the January decay in the options, but when you reach January expiration, could choose to leave the 12 calls long for February. These act as lottery tickets for February, hoping that USO price moves higher.

*Remember to check the value at January expiration.

Example:

If the USO 12 call for February is still worth $35, if you leave it on you could still lose an additional $35 because that is now a new value that could be lost after the January front month expiration. The best time to leave these on as lottery tickets is if they are worth a really small amount.

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  • Bullish Options Strategies [12 Videos]: Naturally everyone wants to make money when the market is heading higher. In this module, we’ll show you how to create specific strategies that profit from up trending markets including low IV strategies like calendars, diagonals, covered calls and direction debit spreads.
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Option Trader Q&A w/ George

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. This week’s question comes from George who asks:

How do you set up the conditional orders to close trades of a certain stock if the market hits a certain situation. For example, if the S&P drops 100-300 points and you want it to trigger to close all trades if that situation were to happen, how do you do that?

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  • Implied Volatility (IV) Percentile Rank [3 Pages]: A cool, simple visual tool to help you understand how we should be trading based on the current IV rank of any particular stock and the best strategies for each blocked section of IV.
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Real-Money, LIVE Trading:

  • EWZ Iron Butterfly (Closing Trade): After nearly pinning the stock at our short strikes, and thanks to the volatility drop, we netted a $600 profit on this iron butterfly trade.
  • VXX Short Call (Closing Trade): One of the most consistent and profitable options trades we can make is shorting pure volatility with VXX and today we closed this naked short call in VXX after a couple days for a $420 profit.
  • DIA Iron Condor (Adjusting Trade): This neutral iron condor in DIA is need of a quick adjustment early this week as the market continues to rally. In this video, we’ll discuss why I’m adding an additional put credit spread while also choosing NOT to close out of our current put credit spread due to pricing reasons.
  • COP Short Put (Closing Trade): These single short puts in COP acted as a great hedge for our other bearish bets in oil this month and helped smooth out our returns after we closed them for a nice big profit.
  • TSLA Put Debit Spread (Closing Trade): Although many people thought we were crazy for getting bearish in TSLA this pre-earnings put debit spread trade made us $200 today. After the huge run up from $140 to $260 and getting some technical sell signals, we were pretty sure this stock would pull back.
  • MON Iron Condor (Closing Trade): Following a huge drop in implied volatility we worked hard to close this MON iron condor trade adjusting the order multiple times to fill before the end of the day.
  • IBB Call Debit Spread (Opening Trade): We’ll show you how I started searching for a new bullish trade and eventually found a low volatility trade in IBB looking for a move higher to hedge our portfolio.
  • TLT Iron Butterfly (Closing Trade): Following the Brexit vote TLT and bonds traded in a nearly $8 range really quickly – even still the drop in implied volatility helped generate a $330 profit for us.
  • XBI Call Debit Spread (Closing Trade): Got lucky picking the exact bottom for our entry in this call debit spread for the XBI biotech ETF which ultimately was closed for a profit of $165 today on the rally higher.
  • COH Iron Butterfly (Earnings Trade): Shortly after the market open we close out of our COH earnings trade for about a $160 profit, leaving just 1 leg on to expire worthless.
  • EWW Debit Spread (Closing Trade): Using some of the technical analysis signals we discovered in our backtesting research, we were able to make a quick $130 profit on this bearish EWW debit spread trade.
  • IBM Iron Condor (Earnings Trade): Shortly after the market opened you’ll follow along with me as we watch volatility drop and liquidity come into the market before closing out the position for $250 profit.
  • SLV Short Straddle (Opening Trade): Using our watch list software we decided to continue to add to our existing SLV short straddle position with a new set of strike prices reflective of the move lower in the ETF recently.

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The calendar spread options strategy

Here is one way to capture opportunities created by volatility.

  • Fidelity Active Investor
  • – 01/25/2020
  • 677

The calendar spread options strategy is a market neutral strategy for seasoned options traders that expect different levels of volatility in the underlying stock at varying points in time, with limited risk in either direction. The goal is to profit from a neutral or directional stock price move to the strike price of the calendar spread with limited risk if the market goes in the other direction.

What is a calendar spread?

A calendar spread typically involves buying and selling the same type of option (calls or puts) for the same underlying security at the same strike price, but at different (albeit small differences in) expiration dates. This type of strategy is also known as a time or horizontal spread due to the differing maturity dates.

A typical long calendar spread involves buying a longer-term option and selling a shorter-term option that is of the same type and exercise price. For example, you might purchase a two-month 100 strike price call and sell a one-month 100 strike price call. This is a debit position, meaning you pay at the outset of the trade.

Calendar spreads are for experienced, knowledgeable traders

The goal of a calendar spread strategy is to take advantage of expected differences in volatility and time decay, while minimizing the impact of movements in the underlying security. The objective for a long call calendar spread is for the underlying stock to be at or near, nearest strike price at expiration and take advantage of near term time decay. Depending on where the stock is relative to the strike price when implemented the forecast can either be neutral, bullish or bearish.

Calendar spread candidates

You can use some of the tools that are available on Fidelity.com to search for calendar spread opportunities. For example, if you select “IV 30 > HV 30” as the criterion, the scan will look for elevated IV levels relative to historical volatility (HV) levels. This specific screen may indicate that certain options are “expensive.”

One-year implied volatility chart

Profit/loss breakdown

The profit/loss diagram of a calendar spread shows that when the stock price increases, this type of trade suffers. Significant movement in either direction in a short period may be costly because of the way the higher gamma (the rate of change, or sensitivity, to a price change in the underlying security for delta) affects short-term contracts.

Another risk to this position is early assignment when selling shorter-term contracts (especially with calls), where the expiration date follows the ex-dividend date. If this is the case, the probability of assignment increases significantly. If assignment occurs prior to the ex-dividend date, the client will owe the dividend payment because the account is now short shares, unless shares of the underlying security are already held in the account.

Early assignment also changes the strategy from a calendar spread to a synthetic long put if you don’t already own shares, because you are short a stock and long a call, which is a very different outlook.

Managing a calendar spread

It is also advisable to check for ex-dividend dates, as it is very important to understand assignment risk—especially for call spreads. You can adjust the spread as necessary to maintain the long position, while adjusting the strike price of the short contract along the way to give more delta exposure.

Calendar spreads with Fidelity

When the short-term expiration date approaches, you will need to make a decision: Sell another front-month contract, close the whole strategy, or allow the long-term call or put to stay in place by itself.

Next steps to consider

Get new options ideas and up-to-the-minute data on options.

Watch a video to learn how you can approach risk management when trading options.

Idea generation, technical analysis, and trading strategy from Viewpoints‘ Active Investor.

About WOT

Through years of experience, our newsletter has developed a solid, shrewd, innovative technique for analyzing the fast moving world of weekly options trading. We discuss trading these volatile weekly options for sustainable profits each and ever week. We send out the newsletter each Friday morning. Our newsletter has become quite adept at assisting those with lofty percentage goals. Speaking with former colleagues & market makers on the CBOE on a weekly basis, the best weekly strategies are derived and written about. The CBOE is largest options exchange in the world, this is where a lifetime of experience was gained in managing risk, mitigating risk, and profiting from risk. A majority of the time, the best weekly options strategy is to focus on spread trading. Experience and knowledge has allowed myself & subscribers to steer away from large losses, while maintaining a steady flow of winning, cash-flow positive trading ideas and statistics.

We hope you decide to follow our options newsletter. Having a firm grasp of where the market is headed short-term is something this newsletter takes great pride in.

William L @ WeeklyOptionsTrading

Calendar Spread

What is a Calendar Spread

A calendar spread is an options or futures spread established by simultaneously entering a long and short position on the same underlying asset at the same strike price but with different delivery months. It is sometimes referred to as an inter-delivery, intra-market, time, or horizontal spread.

The typical options trade comprises the sale of an option (call or put) with a near-term expiration date, and the simultaneous purchase of an option (call or put) with a longer-term expiration. Both options are of the same type and use the same strike price.

  • Sell near-term put/call
  • Buy longer-term put/call
  • Preferable but not required that implied volatility is low

The purpose of the trade is to profit from the passage of time and/or an increase in implied volatility in a directionally neutral strategy.

Basics of a Calendar Spread

Since the goal is to profit from time and volatility, the strike price should be as near as possible to the underlying asset’s price. The trade takes advantage of how near- and long-dated options act when time and volatility change. An increase in implied volatility, all other things held the same, would have a positive impact on this strategy because longer-term options are more sensitive to changes in volatility (higher vega). The caveat is that the two options can and probably will trade at different implied volatilities.

The passage of time, all other things held the same, would have a positive impact on this strategy in the beginning of the trade until the short-term option expires. After that, the strategy is only a long call whose value erodes as time elapses. In general, an option’s rate of time decay (theta) increases as its expiration draws nearer.

Maximum Loss on a Calendar Spread

Since this is a debit spread, the maximum loss is the amount paid for the strategy. The option sold is closer to expiration and therefore has a lower price than the option bought, yielding a net debit or cost.

The ideal market move for profit would be a steady to slightly declining underlying asset price during the life of the near-term option followed by a strong move higher during the life of the far-term option, or a sharp move upward in implied volatility.

At the expiration of the near-term option, the maximum gain would occur when the underlying asset is at or slightly below the strike price of the expiring option. If the asset were higher, the expiring option would have intrinsic value. Once the near-term option expires worthless, the trader is left with a simple long call position, which has no upper limit on its potential profit.

Basically, a trader with a bullish long-term outlook can reduce the cost of purchasing a longer-term call option.

Key Takeaways

  • Calendar spread is a trading strategy for futures and options to minimize risk and cost by buying two contracts or options with the same strike price and different delivery dates.

Example of a Calendar Spread

With Exxon Mobile stock trading at $89.05 in mid-January, 2020:

  • Sell the February 89 call for $0.97 ($970 for one contract)
  • Buy the March 89 call for $2.22 ($2,220 for one contract)

Net cost (debit) $1.25 ($1,250 for one contract)

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