Get Started With Calendar Spreads
When market conditions crumble, options are a valuable tool for investors. Some investors tremble at the mention of the word "options", but there are many options strategies available to help reduce the risk of market volatility. The calendar spread is one method to use during any market climate.
- Trade as either a bullish or bearish strategy.
- Generate profit as time decays.
- Limits risk to the net debit.
- Benefit from an increase in volatility.
- Provide additional leverage to make excess returns.
- Limits losses if the stock price moves dramatically.
Calendar spreads are a great way to combine the advantages of spreads and directional options trades in the same position. Depending on how an investor implements this strategy, they can assume either:
- A market-neutral position that can be rolled out a few times to pay the cost of the spread while taking advantage of time decay
- A short-term market-neutral position with a longer-term directional bias equipped with unlimited gain potential
Either way, the trade can provide many advantages that a plain old call or put cannot provide on its own.
Options are a way to help reduce the risk of market volatility.
Long Calendar Spreads
A long calendar spread—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 with the same strike price but having different expiration months. In essence, if a trader is selling a short-dated option and buying a longer-dated option, the result is net debit to the account. 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.
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 a trader uses calls or puts depends on the sentiment of the underlying investment vehicle. If a trader is bullish, they would buy a calendar call spread. If a trader is bearish, they would buy a calendar put spread.
A long calendar spread is a good strategy to use when prices are expected to expire at the strike price at 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, they 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, the trader can leave the long position in play and reap the benefits of having unlimited profit potential.
Planning the Trade
The first step in planning a trade is to identify market sentiment and a forecast of market conditions over the next few months. Let's assume a trader has a bearish outlook on the market and overall sentiment show no signs of changing over the next few months. In this case, a trader ought to consider a put calendar spread.
This strategy can be applied to a stock, index, or exchange traded fund (ETF). However, for the best results, a trader might consider a liquid vehicle with narrow spreads between bid and ask prices. For our example, we use the DIA, which is the ETF that tracks the Dow Jones Industrial Average.
Figure 1: A bearish reversal pattern on the five-year chart of the DIA
On a one-year chart, prices will appear to be oversold, and 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 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. Typically, spreads move more slowly than most option strategies because each position slightly offsets the other in the short term. If DIA remains above $113 at July's expiration, then the July put will expire worthless leaving the investor long on a September 113 put. In this case, the trader 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, which means they would buy back the July 113 put and sell an August 113 put. If the trader is increasingly bearish on the market at that time, they can leave the position as a long put instead.
The last steps involved in this process are for the trader to establish an exit plan and properly manage their risk. 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 maximum loss in this trade is the net debt 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, the strategy should be considered a covered call. The only difference is that the investor does not own the underlying stock, but the investor does own the right to purchase the underlying stock.
By treating this trade like a covered call, the trader can quickly pick the expiration months. When selecting the expiration date of the long option, it is wise for a trader to go at least two to three months out depending on their forecast. However, when selecting the short strike, it is 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.
- 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 a trader owns calls on a particular stock, and it has made a significant move to the upside but has recently leveled out. A trader can sell a call against this stock if they are neutral over the short term. Traders can use this legging in strategy to ride out the dips in an upward trending stock.
- Plan to Manage Risk
The final trading tip is in regards to managing risk. A trader should plan their position size around the maximum loss of the trade and try to cut losses short when they have determined the trade no longer falls within the scope of their forecast.
- Limited Upside in Early Stages
Calendar trading 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 can result in limited gains.
- Be Aware of Expiration Dates
Expiration dates imply another risk. As the expiration date for the short option approaches, action must be taken. If the short option expires out of the money (OTM), 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, the trader can then decide whether to roll the position.
- Time an Entry Well
The last risk to avoid when trading calendar spreads is an untimely entry. Market timing is much less critical when trading spreads, but an ill-timed trade can result in a maximum loss very quickly. A wise trader surveys the condition of the overall market to make sure they are trading in the direction of the underlying trend of the stock.
The Bottom Line
A long calendar spread is a neutral trading strategy though, in some instances, it can be a directional trading strategy. It is 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 net debit. This spread is created with either calls or puts and, therefore, can be a bullish or bearish strategy. The trader wants the short-dated option to decay at a faster rate than the longer-dated option.