When market conditions are making trading a tricky affair, it can be difficult to know where to look for secure trading. A calendar spread can be a strong medium to long term options strategy to reduce the risk of getting burned by a volatile market and to exploit any market conditions for a decent gain.
What it is
In essence, a calendar spread is a group of Options of the same stock, with the same strike price, but, crucially, with different expiration dates. Options, obviously are a time-sensitive asset, and the calendar spread profits from this sensitivity.
In essence, the trader can integrate the advantages of spreads, the difference between the market value and the strike price, with the pros of a more directional option for a trading strategy. With the strengths of these two styles combined, a calendar spread can almost guarantee profits under any trading conditions.
How calendar spreads work
A calendar spread can work in one of two ways: you can take a market neutral position and benefit from the time decay in the value of the stock options or, alternatively a shorter term market neutral position with a longer-term directional strategy.
Time Spread
A long-term calendar spread strategy, known as a Time Spread is the selling and buying of either a call or put option at the same strike price, but, crucially, those which expire at different times. In its most basic sense, you buy the longer-dated option and sell the shorter dated one. Taking this position on the short-dated option has the effect of bringing down the price of the longer dated one. Thus the trade becomes cheaper than the outright buying of the longer term option.
A long calendar spread can be one of two types. A call strategy or a put one. The put strategy has some advantages over the call, but it depends on your opinion of the underlying stock. Those of a bearish tendency will want to buy a calendar put spread; the more bullish will opt for a call.
The overall effect is to create a relatively neutral, low-risk position which will gain from the time decay of the front option sold short.
For example
Say MegaCorp stock has traded for years at between $55 and $65, this sort of “sideways trading” low volatility stock is perfect for a calendar spread. We can reasonably assume that the selling price isn’t going to shift that much regardless of market conditions. So if the stock’s trading at $61.10 our strategy is first to sell the January, $62.50 calls for $0.30 each then buy the March ones at $0.80 apiece. So the calendar spread’s net debit at this juncture is $0.50. That $0.50 represents the total risk of the trade, which is part of the reasons why calendar spreads are a good option for a canny trader.
Now, in an ideal world, the MegaCorp stock will rise a little before falling below $62.50 at the January expiration. This has the effect of removing all value from the short January call. So with two months to go until the March expiration, without too much volatility in the stock price the March calls value will stand at around $1.70. That’s a profit of $1.20 on the $0.50 spent.
The short term option expiring without making its money is, of course, a best case scenario; not all calendar spreads will work this efficiently. The beauty, though, lies in the flexibility, you still have that long position, so if you think that the market’s going to remain relatively neutral, you have the option of selling another option against that position, effectively rolling the spread over into a new one.
If, however, you feel that the stock is starting to move more in the direction you expected, you have the option of treating it as normal. It’s the ability to cover both ends of the market which make the calendar spread a healthy choice.
The secret’s in the planning
The first thing you need to do when laying the plans for a long-term calendar spread is to get a good feel for the market sentiment surrounding the stock and get a good feel for what trading conditions are going to be like over the next few months. If it’s looking bearish overall, then a put calendar spread is a healthy option.
The next step is to identify your stock. As we’ve already seen, we don’t want a stock that’s too volatile; you wouldn’t want a big difference between the bidding and asking prices.
Once you’re in the trade, close monitoring is essential. If your little option doesn’t decline as much as you’d expect, then the parameters of your overall debit (and the profit you can turn on the extended position) start to shorten. Be vigilant.
The downsides
While a properly managed calendar spread is a relatively low-risk investment strategy, it should be remembered that all investments are risks. Too much market volatility and the long position suddenly becomes a more vulnerable one.
With a time-sensitive strategy such as this, it’s important to make sure you’re keeping a close watch on the option expiration dates and time your entry into the market precisely, to ensure that you’re trading in the general direction of the stock. A mistimed entry running against the market could result in a sizeable loss.
Conclusion
The main thing to remember about calendar spreads is that it is at the start a neutral position, and generates profits only as time decays start to factor in play. It can be used in a bull or bear market, but just make sure you’re running the same way the market is. The number one thing to take away is that a calendar spread is most effective when you expect the price to stay stable in the short term, and move with market trends in the longer term. If that’s what you expect to happen, then this could well be a fruitful trading option for you.
Sources
http://www.nasdaq.com/investing/options-guide/definition-of-options.aspx
http://www.investopedia.com/terms/s/spread.asp
http://www.investinganswers.com/financial-dictionary/optionsderivatives/strike-price-2125
http://www.investorwords.com/6792/directional_trading.html
http://www.call-options.com/what-are-call-options.html
http://www.theoptionsguide.com/put-option.aspx
http://www.investorwords.com/8638/market_sentiment.html
