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This is the most comprehensive guide to the calendar spread option strategy on the planet.
Whether you an absolute beginner option trader or someone who has been around the block for while, but needs a quick refresher, you’ll love this guide.
Before “Calendar Spread Option Strategy: The Definitive Guide”, this information and strategy was scattered all across the internet.
Now, I was able to put them all in one place.
And you can easily follow along so you can learn how to implement the calendar spread into your options trading toolbox.
In this chapter, I’ll show you the exact steps you need to execute the calendar spread.
First, I’ll show you the setup to the calendar spread.
Then, I’ll show you how factors like time and volatility affect the profitability of the calendar spread.
Let’s get started.
The calendar spread strategy is a defined risk options trading strategy that benefits from non-movement in the price of the underlying stock.
The calendar spread takes advantage of time decay and increases in implied volatility to profit.
Here are the exact components of the calendar spread:
This is what the calendar option strategy looks like on a profit and loss diagram:
It is important to note that both options contracts should be situated at the same strike for it to be considered a calendar spread.
Also, front month typically means any options expiration cycle with 30-45 days until expiration.
The back month would be the next consecutive monthly options expiration cycle after that.
The calendar spread option strategy is a debit strategy, meaning you are a net buyer of option premium.
This is because the back month option always has more “extrinsic value” or “time value” since there is a greater number of days until expiration with the back month option relative to the front month option.
So, you end up paying more for the back month option than what you are collecting in option premium from selling the front month option.
What’s unique about the calendar spread, is that it bridges two different expiration cycles.
But because there are two separate expiration cycles involved, you cannot calculate the maximum profit of a calendar spread.
The real variant in determining the maximum profit of the calendar spread is the level of implied volatility at expiration.
If implied volatility is high, then the value of the back month option that you had bought, will increase in value, increasing your profit potential.
If, on the other hand, implied volatility stays the same or decreases, then the value of the back month option will have decayed with time, decreasing your overall profit potential.
Calculating the maximum loss of a calendar spread option strategy is actually quite simple.
All you have to do is look at the initial debit paid to initiate the spread.
You cannot lose any more than what you paid.
When analyzing a calendar spread setup, to make sure you are setting yourself up for success, never pay more for the calendar spread than the price of the front month option.
This means that the calendar spread is a defined risk options strategy.
So, this is a good strategy to use if you have a smaller options trading account or are more risk averse.
Similar to trying to calculate the maximum profit of a calendar spread, it also very difficult to calculate the break even points.
Again, this is due to unknown variables like the level of implied volatility at expiration and multiple expiration cycles.
Some options trading platforms show you the theoretical profit and loss diagram for the calendar spread so you can see where the break even points are.
With that being said, there is one way you can approximate your break even prices for the calendar spread option strategy.
You can do this by looking at 1 strike up and 1 strike down as the approximate break even prices.
This means that as long as the stock price stays within plus or minus one strike, you should be able to make a profit on this strategy.
If, on the other hand, the stock price were to move beyond plus or minus one strike, then you’ll like see some losses.
The calendar option strategy is a theta positive strategy.
This means that the spread makes money as each day passes.
Some traders often get confused on this because with the calendar spread, you are a net buyer of option premium, yet you have positive theta decay.
The reason there’s still positive theta decay with a strategy like the calendar spread is because the front month option has a higher theta decay than the back month option.
Theta decay increases exponentially as expiration approaches.
So, time is on your side for the spread spread.
A calendar spread is often referred to as a "time spread". This is because of how this options trading strategy makes money - through time decay.
The ideal implied volatility environment when you initiate a calendar spread is when implied volatility is low.
When volatility is low, you are able to buy options for a cheaper price.
(Whenever you buy anything, you want to buy it for as cheap as possible)
After you’ve initiated a calendar spread option position, you want implied volatility to rise.
This is because increases in implied volatility will increase the value of the back month option that you bought, allowing you to sell it for a higher price.
(For options trading strategies that work well in high implied volatility, check out the short strangle)
The calendar spread is actually very sensitive to changes in implied volatility.
Let me explain.
The calendar spread is a positive vega options trading strategy meaning increases in implied volatility benefit this strategy.
You may ask yourself, “wouldn’t increases in implied volatility hurt your front month option since you are shorting it?”
The answer is yes.
But, longer dated options have a much larger vega exposure than short dated options.
So, if implied volatility were to increase, the back month option that you had bought would benefit more than it would hurt the front month option that you had sold.
The calendar spread depends on the stock price staying in a relatively narrow predefined range.
If the stock price moves too far away from the calendar spread strikes, then the spread will become a loser.
So, it’s important to only use the calendar option strategy when you think that the stock price is not going to move very much.
In this chapter, I want to show you a real life example of the calendar spread in action.
First, I’ll show you an example trade that I setup in my tastyworks trading account.
Then, I’ll show you how to analyze all the metrics we’ve gone through so far.
Let’s get started.
I’ve constructed a calendar spread option position in GLD to go through all the concepts we’ve learned so far.
Here’s the exact setup:
As you can see, here are the exact strikes I picked for this example:
This whole package is trading for a price of $0.63, which equates to $63 in dollar terms.
This is also the most I can lose on this spread if the stock price doesn’t cooperate.
Here’s a screenshot of all the trade metrics for this particular calendar spread example.
The brokerage platform cannot calculate several metrics for this type of options strategy like probability of profit, maximum profit, and maximum loss.
This is because of the two different expiration cycles involved with this strategy.
For this same reason, you cannot calculate an exact break even price.
But, we can estimate that the stock price needs to stay somewhere between 118 and 120 to achieve some level of profitability.
Outside those two stock prices, this calendar spread is likely to lose money.
So, with all these unknowns, what are we able to determine about this particular calendar spread example?
Well, first, we know that we want the stock price to stay within a range. For this example, somewhere between 118 and 120.
We also know that this spread will make about $0.30 in theta decay per day.
Lastly, we know that we want the level of implied volatility to increase at some point during the life of the trade, so we can exit the spread for a higher price than we had bought it for.
In this chapter, I’ll share with you some tips and criteria you can use to determine whether to use a put calendar or a call calendar spread.
As you know, the calendar spread can be executed by either using calls or puts.
Here’s how to know when to use each:
If it wasn’t clear already, you can construct the calendar spread option strategy using either call options or put options.
Put Calendar Spread vs. Call Calendar Spread
A put calendar spread is a type of calendar spread that is made up entirely of put options, while a call calendar spread is a type of calendar spread that is made up entirely of call options.
The result, if you use calls or puts is essentially identical, assuming you use the same strikes and same expiration cycles.
So, what’s the difference and when should you use one over the other?
Let me answer that question.
It all boils down to whether you have a directional bias on the underlying stock price.
If you’re slightly bullish on the stock price, you’d want to opt for the call calendar spread over the put calendar spread.
If, on the other hand, you are slightly bearish on the stock price, you’d want to opt for the put calendar spread over the call calendar spread.
Why is that?
The reason is not due to some strategic advantage of one over the other…
In fact, if you did a put calendar spread situated at strike X and a call calendar spread situated at strike X, they would be the exact same position.
The reason more lies in the liquidity of the underlying options.
Out of the money options tend to be much more liquid than in the money options.
Because of that fact, I like to stick with the more liquid options since I’ll get a better price and have an easier time existing the position.
So, if you’re slightly bullish, the out of the money call options make more sense than the in the money put options, even if they’re the exact same.
The same goes for the opposite.
There is one popular variant on the calendar spread option strategy.
And that is the double calendar.
I’ve seen lots of other traders use this strategy even though it’s pretty uncommon.
So, without further ado, let’s get started.
There’s a slightly more complicated version of the simple calendar spread, which is the double calendar spread.
Before getting too deep into the details, it’s important to note that the intent and mechanics of a double calendar is very similar to the single calendar spread.
Double Calendar Spread
A double calendar spread is the combination of two calendar spreads. One put calendar spread below the current stock price and one call calendar spread above the current stock price.
For both the standard calendar spread options strategy and the double calendar spread, you want to initiate the trade in low implied volatility environments in hopes of a rise in implied volatility.
You also want minimal movement in the underlying stock price in both cases.
So, the main difference with the double calendar is that you establish a call calendar spread above the current stock price and put calendar spread below the current stock price.
Here’s an example of how that works:
This is what that looks like on a profit and loss diagram:
As you can see, the double calendar spread is the combination of both a call and put calendar spreads.
As for the specific strike selection, you want to situate the put calendar spread below the current stock price, while the call calendar spread should be situated above the current stock price.
The effect of time and volatility is nearly identical in this case as for the single calendar.
Similarly, your maximum loss is the amount you pay for both calendar spreads and your break even price is approximately one strike below the put strike and one strike above the call strike.
The best outcome for you with the double calendar spread is for time to pass, volatility to increase, and for the stock price to lane somewhere in between the two calendar spreads.
The one benefit that the double calendar spread has over the single calendar spread option strategy is that the double calendar spread has a much larger range of profitability, giving the stock price additional room to move, thus a higher probability of success.
Now I’d like to hear from you:
Which type of calendar spread option strategy from today’s guide do you want to try first?
Are you going to implement this type of strategy in your options trading portfolio for low implied volatility environments?
Or maybe you’re ready to try out the double calendar?
Either way, leave me a comment below to let me know, right now.
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