When market conditions crumble, options become a valuable tool to investors. While many investors tremble at the mention of the word "options," there are many option strategies available to help reduce the risk of market volatility. In this article we are going to examine the many uses of the calendar spread and discuss how to make this strategy work during any market climate.
Getting Started With Calendar Spreads
Calendar spreads are a great way to combine the advantages of spreads and directional option trades in the same position. Depending on how you implement this strategy, you can have either:
Either way, the trade can provide many advantages that a plain old call or put cannot provide on its own.
Long Calendar Spreads
A long calendar spread, which is often referred to as a time spread, is the buying and selling of a call option or the buying and selling of a put option of the same strike price but different expiration months. In essence, you are selling a short-dated option and buying a longer-dated option. The result is a net debit to the account. In fact, the sale of the short-dated option reduces the price of the long-dated option, making the trade less expensive than buying the long-dated option outright. Because the two options expire in different months, this trade can take on many different forms as expiration months pass. (For more, see: Option Spread Strategies.)
There are two types of long calendar spreads: call and put. There are inherent advantages to trading a put calendar over a call calendar, but both are readily acceptable trades. Whether you use calls or puts depends on your sentiment of the underlying investment vehicle. If you are bullish, you would buy a calendar call spread. If you are bearish, you would buy a calendar put spread.
A long calendar spread is a good strategy to use when you expect prices to expire at the value of the strike price you are trading at the expiry of the front-month option. This strategy is ideal for a trader whose short-term sentiment is neutral. Ideally, the short-dated option will expire out of the money. Once this happens, the trader is left with a long option position.
If the trader still has a neutral forecast, he or she can choose to sell another option against the long position, legging into another spread. On the other hand, if the trader now feels the stock will start to move in the direction of the longer-term forecast, he or she can leave the long position in play and reap the benefits of having unlimited profit potential. (For related reading, see: How do I set a strike price in an options spread?)
Planning the Trade
The first step in planning a trade is to identify a market sentiment and forecast what market conditions will be like over the next few months. Let's assume we have a bearish outlook on the market and the overall sentiment doesn't show any signs of changing over the next few months. In this case, we ought to consider a put calendar spread.
This strategy can be applied to a stock, index or ETF offering options. However, for the best results, consider an extremely liquid vehicle with very narrow spreads between bid and ask prices. For our example, we will use the DIA, which is the ETF that tracks the Dow Jones Industrial Average.
On this five-year chart (Figure 1), recent price action indicates a reversal pattern known as the head-and-shoulders pattern. Prices have recently confirmed this pattern, which suggests a continued downside. (For more insight, see: Analyzing Chart Patterns: Head And Shoulders.)
Figure 1: A bearish reversal pattern on the five-year chart of the DIA
If you look at a one-year chart, you'll see prices are oversold, and you are likely to see prices consolidate in the short term. Based on these metrics, a calendar spread would be a good fit. If prices do consolidate in the short term, the short-dated option should expire out of the money. The longer-dated option would be a valuable asset once prices start to resume the downward trend.
Based on the price shown in the chart of the DIA, which is $113.84, we'll look at the prices of the July and August 113 puts. Here is what the trade looks like:
- Bought September DIA 113 puts: -$4.30
- Sold July DIA 113 puts: +$1.76
- Net debit: $2.54
Upon entering the trade, it is important to know how it will react. Generally speaking, spreads move much more slowly than most option strategies. This is because each position slightly offsets the other in the short-term. If the DIA remains above $113 at July's expiration, then the July put will expire worthless, leaving the investor long a September 113 put. In this case, you will want the market to move as much as possible to the downside. The more it moves, the more profitable this trade becomes.
If prices are below $113, the investor can choose to roll out the position at that time, meaning they would buy back the July 113 put and sell an August 113 put. If you are increasingly bearish on the market at that time, you can leave the position as a long put instead.
The last steps involved in this process are to establish an exit plan and make sure you have properly managed your risk. A proper position size will help to manage risk, but a trader should also make sure they have an exit strategy in mind when taking the trade. As it stands, the max loss in this trade is the net debit of $2.54.
There are a few trading tips to consider when trading calendar spreads.
Pick Expiration Months as for a Covered Call
When trading a calendar spread, try to think of this strategy as a covered call. The only difference is you do not own the underlying stock, but you do own the right to purchase it.
By treating this trade like a covered call, it will help you pick expiration months quickly. When selecting the expiration date of the long option, it is wise to go at least two to three months out. This will depend largely on your forecast. However, when selecting the short strike, it is a good practice to always sell the shortest dated option available. These options lose value the fastest, and can be rolled out month-to-month over the life of the trade. (To learn more, read: The Basics Of Covered Calls.)
Leg Into a Calendar Spread
For traders who own calls or puts against a stock, they can sell an option against this position and leg into a calendar spread at any point. For example, if you own calls on a particular stock and it has made a significant move to the upside but has recently leveled out, you can sell a call against this stock if you are neutral over the short-term. Traders can use this legging-in strategy to ride out the dips in an upward trending stock. (To learn more, see: An Alternative Covered Call: Adding a Leg.)
Plan to Manage Risk
The final trading tip is in regards to managing risk. Plan your position size around the max loss of the trade and try to cut losses short when you have determined the trade no longer falls within the scope of your forecast.
What to Avoid
Like any trading strategy, it is important to know the risks and downsides involved.
Limited Upside in the Early Stages
It is important to know this trade has limited upside when both legs are in play. However, once the short option expires, the remaining long position has unlimited profit potential. In the early stages of this trade, it is a neutral trading strategy. If the stock starts to move more than anticipated, this is what can result in limited gains.
Be Aware of Expiration Dates
Speaking of expiration dates, this is another risk to plan for. As the expiration date for the short option approaches, action needs to be taken. If the short option expires out of the money, then the contract expires worthless. If the option is in the money, the trader should consider buying back the option at the market price. After the trader has taken action with the short option, he or she can then decide whether to roll the position.
Time Your Entry Well
The last risk to avoid when trading calendar spreads is an untimely entry. In general, market timing is much less critical when trading spreads, but a trade that is very ill-timed can result in a max loss very quickly. Survey the condition of the overall market and to make sure you are trading within the direction of the underlying trend of the stock.
The Bottom Line
Remember a long calendar spread is a neutral, and in some instances a directional, trading strategy used when a trader expects a gradual or sideways movement in the short-term and has more direction bias over the life of the longer-dated option. This trade is constructed by selling a short-dated option and buying a longer-dated option, resulting in a net debit. This spread can be created with either calls or puts, and therefore can be a bullish or bearish strategy. The trader wants to see the short-dated option decay at a faster rate than the longer-dated option.
Here are a few key points to remember. Calendar spreads:
- Can be traded as either a bullish or bearish strategy;
- Generate profit as time decays;
- Limit risk to the net debit;
- Benefit from an increase in volatility;
- Provide additional leverage to make excess returns; and
- Limits losses if the stock price moves dramatically.
(For further reading, see: Trading Calendar Spreads in Grain Markets.)