Introduction
A calendar spread is an options strategy used to take advantage of predicted changes in the price of an underlying security, with low risk. This involves buying or selling calls or puts with different strike prices, but with the same expiry date. For example, if you think a stock will go down, but don’t want to short sell it, you can buy at-the-money calls and sell out-of-the-money calls with a long duration.
Calendar spreads decrease expenses related to time decay and delta model estimations. When planned well, this strategy can bring passive revenue without ever owning the underlying asset for long.
It’s an attractive strategy for those looking for regular returns, by buying long dated expirations and selling short dated expirations. You can make money in both up and down markets, making it suitable for conservative investors who want quality returns in uncertain times.
To enter these trades, you need to understand how calendar spreads work. This article covers:
- What are calendar spreads?
- Risk evaluation
- Setting up your trades
- Profitability evaluation
- Implementation strategies
Let’s get started!
What Are Calendar Spreads?
Calendar spreads are a particular type of options trading. This involves buying a longer-term option and selling a shorter-term one at the same strike price. You can do this with either calls or puts. This is seen as a way of managing volatility. The aim is to make a profit from the difference between the two premiums.
Here we’ll discuss the risks, setups, and profits of trading calendar spreads:
Definition
Calendar spreads, also known as horizontal spreads, involve buying and selling options with the same underlying asset and strike price. However, the expiration dates are different. This trade is used for capitalizing on changes in the time value of each option.
It is important to note that calendar spreads do not provide any leverage for taking advantage of market direction or volatility like other strategies.
To create a calendar spread, one can either use two puts (buying a longer-term put and selling a near-term put), two calls (buying a longer-term call and selling a near-term call), or one of each. All strategies hold the same underlying stock, strike price, and expiration months which are usually no more than two months apart. The aim is to make profits off the changes in the time value within each option, as well as the implied volatility changes between these positions across various months.
Mechanics of a Calendar Spread
Calendar spreads are an options trading strategy. It involves taking a long (or short) position in an option expiring in a certain month. At the same time, an offsetting short (or long) position is taken in the same option series but with a different expiration date. This is also known as Horizontal Spreads as the two positions have the same underlying security, strike price and option type.
The purpose of using calendar spreads is to speculate on the direction of the underlying asset before both options expire. The longer the expiration of one of the legs, compared to the other, the greater the net credit/debit amount when entering the position. Bigger net credit/debit usually leads to higher profits (or lower losses).
Traders generally open a calendar spread with two legs:
- The Long Leg: Buy one option contract and keep it until expiry.
- The Short Leg: Sell one option contract and close it before expiration.
Calendar spreads generally involve selling options with high premiums. Short expirations skew risk/reward ratios in favor of selling covered calls when low implied volatility is present. Long expirations are held for protection against drastic price swings for a long time. Calendar spreads offer levered exposure to directional moves in stock prices without risking extra capital, with sound money management and setup fees taken into consideration.
Risks of Trading Calendar Spreads
Calendar spread trading can bring in big profits. But it also comes with big risks! In this article, we’ll explore those risks. We’ll go over typical set-ups, profits, and other dangers. Let’s dive in and check out the risks of trading calendar spreads!
Volatility Risk
Volatility is a risk for those trading calendar spreads. It means price changes could move against the trader. Implied volatility can decrease or increase the spread’s value.
It affects calendar spread prices in three ways:
- When implied volatility rises, long call and put spreads become less profitable, while short spreads become more costly.
- Small price shifts cause bigger losses or profits.
- Higher implied volatility leads to wider bid/ask spreads, which add to costs.
Therefore, traders must stay aware of their exposure to volatility changes. Manage size and hedge with straddles or strangles. Be mindful of implied volatilities when trading calendar spreads. Take steps to ensure consistent profitability.
Time Decay Risk
Time decay risk is usually higher in calendar trading than in other types of options trading. This is because one option will go up in value much faster than the other (due to its closer expiration date). This fast appreciation, or ‘time decay’, means traders must exit their spread position before losses become too big. A trailing stop point is the best way to protect against this risk. This lets traders leave when their maximum acceptable loss has been reached.
As expiration nears, calendars become more time-sensitive. Traders must continually review their positions and check for any market changes. Additionally, when options move away from the money, the rate of time decay grows fast – so it’s important to keep this in mind when trading calendars or similar strategies that are affected by time value.
Setting Up Calendar Spreads
Calendar spreads offer traders potential profits, but also come with risks. To do a calendar spread, buy an option with a far-off expiration date and sell one with a near expiration date. Setting up a successful calendar spread is key.
In this article, we’ll look at what to consider when setting up a calendar spread:
Selecting the Right Underlying
When picking an underlying for a calendar spread, it’s critical to get the connection between option prices, volatility, and implied volatility. High-volatility trades are great for calendar spreads because they come from quick price changes. Generally, stocks, indices, and ETFs have low enough volatility to work well in conservative calendar spread positions.
Before trading, you need to set up risk parameters by researching all of the options. To pick the best assets, see liquidity, market depth, and implied volatility between the expirations. You should also guess which direction the underlying asset will move to find the expiration date with the highest profit.
Selecting the right asset is about finding the balance between risk and reward. Exercise caution and do research to understand the trade before investing. This way, you can sail uncharted waters with more trust knowing you did your due diligence.
Choosing the Right Strike Prices
Strike prices for calendar spreads should be chosen with attention. This depends on volatility, implied volatility (IV), delta, cost of the spread, and directional bias.
- Volatility is the price movement of the underlying. It’s measured by how far an option may move in a period. Higher volatility leads to wider spreads.
- High IV means expensive options. Low IV means cheap options.
- Delta measures how much an option changes compared to the asset. Profitability when trading with spreads is affected by this.
Cost of the spread should be calculated before trading. Fees, commissions and bid-ask spreads should be taken into account. Directional bias shows which situation is favorable when setting up calendar spreads. Choosing quality strike prices can lead to higher rewards or lower risk. Higher rewards usually mean higher risk. So, risk should be managed when doing spread trading.
Setting the Right Expiration Dates
Traders must pick expiration dates for calendar spreads carefully. This involves looking at market conditions, profit goals, and risk tolerance.
The ideal situation is a “short calendar spread”. That’s when you buy a call option with a near-term expiration date and a put option with a slightly farther out expiration date. This spread works better with small movements in the underlying stock price than large ones.
“Long calendar spreads” involve buying an option with more distant expiration. That way you get more time for the strategy to work out, but you also pay more in premiums.
“Diagonal spreads” sell one month and buy another farther out, while paying less upfront. Diagonal spreads are good for large moves quickly over shorter time periods, and they also reduce exposure to losses from time decay.
Profitability of Calendar Spreads
Calendar spreads are renowned for being profitable. You buy one option and then sell another option with the same strike price but different expiration date. This lets you benefit from time decay and volatility. But, be warned, this strategy does come with risks.
Let’s delve into the profitability of calendar spreads, as well as potential trading setups and risks:
Break-Even Point
The break-even point of a calendar spread is the price when there is no net gain or loss. This is worked out by adding together both legs of the spread and subtracting any net premiums. Taking into account fees and commissions makes this figure more accurate. If the stock prices stay above or below the break-even point, it leads to a gain or loss.
It’s essential to remember that the figure can change quickly due to market conditions. Also, IV and time decay can impact a trader’s profits. To maximize returns and reduce potential losses, traders must pay attention to both calendar and directional risk when trading these strategies.
Maximum Loss
It’s essential to know the risks when trading calendar spreads. This includes a potential loss of time and money. The max loss is the net debit from the start, plus fees.
It’s best to not use too much margin, so losses can be minimized. When prices move faster than expected, losses may be seen. To avoid further losses, traders may close trades before expiration at a lower price than their entry.
Maximum Profit
When trading calendar spreads, the max profit is limited. It happens when the near-term option’s price gets to zero. This is because the near-term option’s value decreases, which offsets the cost of buying it and any losses from buying the far-term option. The profitable outcome means both options expire in-the-money on expiration day and can be exercised for a total profit.
For example, if you think the underlying will stay the same, you can buy a longer-dated option at a lower cost than shorter term contracts. With calendar spreads, two options are bought: one expiring soon (usually 1 month) and the other expiring farther away (3 or 6 months). You pay less for the longer-term option than you would for two shorter term ones. This strategy gives downside protection without reducing max profitability.
However, this strategy has risks. Market movements can cause lost time value in either or both options, leading to reduced profits or losses. If used correctly, calendar spreads offer good risk/reward profiles, resulting in consistent profits over time with few surprises.
Conclusion
Calendar spreads can be a great strategy for traders. They have higher pay-offs than other strategies and limited risk exposure. Plus, they need smaller capital outlays than long or short positions.
Before starting, it is important to understand the risks. Research the markets and type of calendar spread, including adjustments and sizes of contracts.
To have a successful trading experience, understand the trade set up, profitability and risks. Know the maximum stock risk exposure limits, adjustments, option prices and availability across markets. This will equip traders to open positions with confidence.
Frequently Asked Questions
Q1: What is a calendar spread?
A1: A calendar spread is an options trading strategy involving simultaneously purchasing and selling call or put options with different expiration dates but at the same strike price. This strategy can be employed to take advantage of differences in the pricing of near-term and longer-term options.
Q2: What are the risks of trading calendar spreads?
A2: The main risk of trading calendar spreads is that the market can move in the opposite direction of your position, resulting in a loss. Additionally, you may also incur losses if the spread widens or narrows too quickly, and you may be subject to assignment risk if you are holding a long option position.
Q3: What is the most profitable way to trade calendar spreads?
A3: The most profitable way to trade calendar spreads is to buy when implied volatility is low and sell when it is high. Additionally, it is important to identify profitable setups and manage risk carefully.
