Calendar Spread Explained

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Long Calendar Spread w/Calls

AKA Time Spread; Horizontal Spread

NOTE: The profit and loss lines are not straight. That’s because the back-month call is still open when the front-month call expires. Straight lines and hard angles usually indicate that all options in the strategy have the same expiration date.

The Strategy

When running a calendar spread with calls, you’re selling and buying a call with the same strike price, but the call you buy will have a later expiration date than the call you sell. You’re taking advantage of accelerating time decay on the front-month (shorter-term) call as expiration approaches. Just before front-month expiration, you want to buy back the shorter-term call for next to nothing. At the same time, you will sell the back-month call to close your position. Ideally, the back-month call will still have significant time value.

If you’re anticipating minimal movement on the stock, construct your calendar spread with at-the-money calls. If you’re mildly bullish, use slightly out-of-the-money calls. This can give you a lower up-front cost

Because the front-month and back-month options both have the same strike price, you can’t capture any intrinsic value on the options. You can only capture time value. However, as the calls get deep in-the-money or far out-of-the-money, time value will begin to disappear. Time value is maximized with at-the-money options, so you need the stock price to stay as close to strike A as possible.

For this Playbook, I’m using the example of a one-month calendar spread. But please note it is possible to use different time intervals. If you’re going to use more than a one-month interval between the front-month and back-month options, you need to understand the ins and outs of rolling an option position.

Options Guy’s Tips

When establishing one-month calendar spreads, you may wish to consider a “risk one to make two” philosophy. That is, for every net debit of $1 at initiation, you’re hoping to receive $2 when closing the position. Use Ally Invest’s Profit + Loss Calculator to estimate whether this seems possible.

To run this strategy, you need to know how to manage the risk of early assignment on your short options. So be sure to read What is Early Exercise and Assignment and Why Does it Happen?

The Setup

  • Sell a call, strike price A (near-term expiration — “front-month”)
  • Buy a call, strike price A (with expiration one month later — “back-month”)
  • Generally, the stock will be at or around strike A

Who Should Run It

Seasoned Veterans and higher

NOTE: The level of knowledge required for this trade is considerable, because you’re dealing with options that expire on different dates.

When to Run It

You’re anticipating minimal movement on the stock within a specific time frame.

Break-even at Expiration

It is possible to approximate break-even points, but there are too many variables to give an exact formula.

Because there are two expiration dates for the options in a calendar spread, a pricing model must be used to “guesstimate” what the value of the back-month call will be when the front-month call expires. Ally Invest’s Profit + Loss Calculator can help you in this regard. But keep in mind, the Profit + Loss Calculator assumes that all other variables, such as implied volatility, interest rates, etc., remain constant over the life of the trade — and they may not behave that way in reality.

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The Sweet Spot

You want the stock price to be at strike A when the front-month option expires.

Maximum Potential Profit

Potential profit is limited to the premium received for the back-month call minus the cost to buy back the front-month call, minus the net debit paid to establish the position.

Maximum Potential Loss

Limited to the net debit paid to establish the trade.

NOTE: You can’t precisely calculate your risk at initiation of this strategy, because it depends on how the back-month call performs.

Ally Invest Margin Requirement

After the trade is paid for, no additional margin is required if the position is closed at expiration of the front-month option.

As Time Goes By

For this strategy, time decay is your friend. Because time decay accelerates close to expiration, the front-month call will lose value faster than the back-month call.

Implied Volatility

After the strategy is established, although you don’t want the stock to move much, you’re better off if implied volatility increases close to front-month expiration. That will cause the back-month call price to increase, while having little effect on the price of the front-month option. (Near expiration, there is hardly any time value for implied volatility to mess with.)

Check your strategy with Ally Invest tools

  • Use the Profit + Loss Calculator to estimate break-even points, evaluate how your strategy might change as expiration approaches, and analyze the Option Greeks.
  • Use the Profit + Loss Calculator to estimate profit potential by determining what the back-month option will be trading for at the expiration of the front month.

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Using Calendar Spreads To Profit In Any Market Condition

Using Calendar Spreads To Profit In Any Market Condition

Many stock investors are fearful when it comes to trading options. Horror stories abound on financial message boards about traders who were wiped out or took huge losses when venturing into the options arena. While these stories are likely true, it’s critical to note that the losses are due to the investor’s inexperience or disregard for the risky nature of options. Like in all types of investing, risk is part of the game in options. Knowledge is what prevents fear and turns options into profit making tools.

The good news is that by understanding the variety of option strategies, options can be used to actually reduce or control risk in the stock market.

One of these highly effective risk controlling strategies is called a Calendar Spread. This strategy involves the combination of a risk-reducing spread trade with the profit making opportunity of a directional trade in the same trade. Calendar Spreads truly give the power to option traders!!

The cool thing about Calendar Spreads is their flexibility. Calendar Spreads can be used in multiple market conditions.

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First, this type of spread can be a market neutral position that can be extended ( rolled over) to cover the cost of the spread while taking advantage of time decay. As you likely know, time decay is the bane of option buyers. Every day that passes for option buyers reduces the price of the option. The blunt weapon method of taking advantage of time decay is to be an option seller. While selling options can create a steady stream of income, the risk level is very high when selling naked. Naked means to sell a put or call without any type of hedge that will protect your equity should the option take off on the upside. Even professional option traders sometimes get burned when selling options. I know of several large hedge funds that were nearly wiped out when their option selling programs hit black swan style adverse market conditions.

The great news is Calendar Spreads allow you to take advantage of time decay without the outright risk of selling options.

Secondly, Calendar Spreads can be used to initiate short term market neutral positions that have a longer timeframe directional bias yet can participate in unlimited upside potential.

Prior to explaining how simple it is to create and profit from Calendar Spreads across different market conditions, let’s first look at the basic building blocks of the Calendar Spread.

A Primer On The Basic Components of a Calendar Spread

Calendar Spreads are built on buying and selling puts and call options; a put option is purchased if you expect the underlying stock to go down. Traders sell put options when you expect the underlying stock to climb in value.

Call options profit when the underlying stock increases in value. Calls are sold when you expect the underlying stock to fall in value.

Each option symbolizes 100 shares of the stock and has a limited lifespan. Options are characterized in a code like arrangement that consist of the root symbol + expiration month code + strike price.

Options are characterized in a code like arrangement that consist of the root symbol + expiration month code + strike price.

Just what do these terms mean? The root symbol refers to the stock symbol but is not the same as the ticker symbol. Root symbols can be found by looking at the options available for each stock via your broker or one of the many free option information services on the web. The expiration month code is the code for the month the option expires—January through December. Options normally expire around the 15 th of each month for that month. Strike Price is the price where the option begins to have intrinsic value, meaning actual worth and simply not just time value. If the option has a strike price greater than the price of the stock, a PUT is said to be “in the money” and a CALL would be “out of the money” and vice versa. Here is a chart illustrating the options codes.

This information is critical to know when choosing options for calendar spreads.

JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC
Calls A B C D E F G H I J K L
Puts M N O P Q R S T U V W X
Strike Price Codes
Code Strike Prices
A 5 105 205 305 405 505
B 10 110 210 310 410 510
C 15 115 215 315 415 515
D 20 120 220 320 420 520
E 25 125 225 325 425 525
F 30 130 230 330 430 530
G 35 135 235 335 435 535
H 40 140 240 340 440 540
I 45 145 245 345 445 545
J 50 150 250 350 450 550
K 55 155 255 355 455 555
L 60 160 260 360 460 560
M 65 165 265 365 465 565
Code Strike Prices
N 70 170 270 370 470 570
O 75 175 275 375 475 575
P 80 180 280 380 480 580
Q 85 185 285 385 485 585
R 90 190 290 390 490 590
S 95 195 295 395 495 595
T 100 200 300 400 500 600
U 7.5 37.5 67.5 97.5 127.5 157.5
V 12.5 42.5 72.5 102.5 132.5 162.5
W 17.5 47.5 77.5 107.5 137.5 167.5
X 22.5 52.5 82.5 112.5 142.5 172.5
Y 27.5 57.5 87.5 117.5 147.5 177.5
Z 32.5 62.5 92.5 122.5 152.5 182.5

Calendar Spreads Explained

The easiest to understand Calendar Spread is known as the time spread. It is the buying and selling of a call or a put of the same expiration price, yet different expiration months. The way it works is you sell the short-dated option and buy the long-dated option. In other words, you want to buy the time premium inherent in the option that has a further away expiration date and sell the time premium in the option that expires sooner. Your account will experience a net debit on the trade, but this debit is reduced by the sale of the short dated option. Advanced traders can work this spread in a variety of ways as expiration draws closer.

Calendar Spreads can be used with either puts or calls. If you are bullish on the underlying, use calls. If your bias runs bearish, utilize puts for the spread.

The ideal end game for the spread is for the underlying to expire at the strike price of the options. Locating stocks that are trading long term in tight channels are the ideal stocks for this strategy. Calendar Spreads makes the most sense for traders who have a short term neutral bias but a bullish longer term bias. The bet is that the short dated option expires out of the money and you get to keep the premium. This leaves you with a long call that has some time prior to expiration.

Now, if you maintain your neutral bias upon expiration of the short dated option, you can sell another one to create another credit to your account.

Here Are A Few Hints

1. Leg Into Time Spreads

You don’t need to put on a time spread all at once. If you own puts or calls and the underlying is flat, you can always create a time spread to created income.

2. Timing is Critical

Think of the spread as a covered call. This means its best to go at least three months out for the long dated option. At the same time, sell the earliest expiring option to create income with the least risk.

3. Be Aware of Risk

Always be prepared to lose the maximum possible on the trade. This way you are prepared for the worst situation and can position size to control your overall account risk factor.

Double Calendar Spread Options Strategy

A double calendar spread is an options trading strategy that takes advantage of the one certainty associated with all options contracts – they all expire at some point. Consequently, it is a favorite advanced strategy used by market professionals. Why? Because it entails minimal risk and can be managed in such a way that even potentially losing positions can be turned into profitable ones.

If you know what a calendar spread is, then you’ll understand that the double calendar is simply an extension of this principle. It relies on the underlying stock or ETF to remain within a trading price range up to the expiration date of the sold options. This is how you profit.

Advantages of the Double Calendar Spread

Unlike a calendar spread, the double calendar spread extends, or widens the range within which a profit can be realized. Not only so, but whereas a simple calendar spread uses only call or put options, the double calendar uses both – and does so at the upper and lower ends of the trading range that you choose.

Looking at it another way, you could say that the double calendar spread is like a short straddle or strangle strategy, but with additional positions added. These additional positions are long options and with a later month expiration date, on either side.

Since the later month long positions will cost more than the earlier month short positions, the spread will incur a net debit to your account. This debit will also be the maximum risk for this strategy.

Double Calendar Spread Example

Let’s say we are entering our position in May of any given year.

We sell an equal number of June call and put options at strike prices, say $20 apart (let’s assume $50 puts and $70 calls). There’s our short “strangle” done.

To this setup we now add the purchase (going long) of the same number of calls and puts, but with July expiration dates and the same strike prices. So in the case of our example here, we would buy July $50 puts and also July $70 calls.

Most reputable brokers will allow you to enter all 4 positions as one trade, rather than legging into them. But if you must leg into the trade, do one calendar spread first and then the next one.

Looking at the risk graph below, you’ll see that it looks like a “tent”. If the earlier month short options expire within the prices displayed in the tent, you take a profit.

Continuing our example, should the underlying price action of the underlying subsequently explode beyond the $50 or $70 levels, one of your June expiration short sold options will increase in value while the other will be way out of the money and therefore, decline. At this point you could choose to buy back your losing ‘sold’ option for next to nothing and continue holding the losing July long position, allowing for the possibility of a reversal.

Your other ‘sold’ option (the one whose strike price has been breached) would ordinarily expose you to unlimited risk but this will be protected by your longer dated bought option, since they have the same strike price.

The same principle can be applied to convert straddles into a double calendar spread, if the anticipated price explosion needed for straddles to profit, doesn’t take place. Only in this case the strike prices are all the same.

Double Calendar Spread – Criteria for Entry

Before you consider placing a double calendar spread, there are a couple of things you need to see in both the underlying and the options themselves.

1. You should believe that the underlying will remain within a trading range for the duration of your short options’ lifespan – so taking our example above, until June expiration date.

But here’s the real important one.

2. You should also look at the options implied volatility for both the near month and later month options. The best trades are made when you see a “volatility skew”. These occur when the near month options have a higher implied volatility than the later month options. Since you want to sell the near month options, you would like to receive as much as possible and this is why you look for these skews.

If the longer dated options have a higher implied volatility than the shorter dates ones, stay out of the trade.

If the volatility skew is too good, it could be telling you that an upcoming company earnings report is approaching. Since these can produce unpredictable results for stock prices, you should first check that an earnings report is NOT on the horizon before placing the double calendar spread trade. This is one reason why ETF options might be preferable than company stock options. If the volatility skew is a natural one and shows at least a 2 percent difference, you have a good candidate for entry.

3. Your short positions should be no more than 30 days until expiration because during the final 30 days, out of the money options decline in value more rapidly. Your long positions can be one or two months later.

Before executing your double calendar spread, the final thing you need to look at is a risk profile graph. Ideally, it should look like a “tent” as in the example above, with two peaks and a slight dip in the middle. The risk graph will show a range of stock prices at which the position will make a profit.

Ideally, the current market price of the underlying at time of entry should be in the centre of the risk graph. This will allow you enough movement to the upside or downside before your breakeven points are breached and any adjustments may be necessary.

The beauty of this strategy is that because you are on the selling end of options contracts, you have ‘theta’ or ‘time decay’ working in your favor. Maximum profits are achieved when your near month options both expire worthless because ‘at-the-money’ while your long dated options still have enough time value to close the whole position for a profit.

Finally, you should NEVER simply put this type of trade on and then just hope that the underlying will remain within the desired range until your short options expire.

The Vital Ingredient for Success

THE SECRET to making CONSISTENT PROFITS with double calendar spreads, is to learn the art of adjustments.

How and when to make these adjustments is explained in depth, in the very popular Trading Pro System video series. Knowing how to interpret “the numbers” so that you can adjust your positions, is the key to a consistent monthly income stream that will never fail.

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