Calendar spreads are a great modification of the diagonal option spread strategy. The calendar spread is useful when you are more uncertain about the direction of the market and want to increase the effectiveness of the hedge during periods of market volatility.
In this article I will demonstrate this strategy with a trade that has a slightly bearish bias. You could experiment by shifting strike prices in a paper trade to be more neutral or bullish. The first option is a long put with a long term expiration date. The long term put establishes the bearish bias and will grow in value as the market drops.
The second option is a short put with a short term expiration. The short put has the same strike price as the long put you purchased. The identical strike price but different expiration dates is what makes this a calendar spread. The ratio of the premium received from the short put to the price you paid for the long put is much larger than the same ratio in a diagonal spread. However, because the short put has the same strike price as the long put, there are smaller potential profits if the market breaks out to the downside.
In the video, I will cover the details of entering a sample bearish calendar spread. The larger premium compared to the amount invested in the long put creates a large hedge against upside movement in the market. If prices rise, the larger premium from the short put will offset more losses than a short put in a diagonal spread. However, if the market never returns after a rally the long side of the trade will have accumulated losses.
This is still a great way to implement the benefits of a diagonal spread in the market when you are uncertain but have a bearish bias. The short leg of the calendar spread is designed to reduce the amount of the spread cost attributable to time value thereby increasing the possibilities for profits.
Since initially setting up this trade the market has rallied. This is a great opportunity to look current option prices before March expiration and see how the calendar spread has protected the trade against some losses. The short leg of the trade is essentially a bullish hedge selling a put is bullish and will have offset some of the losses on the long side.
If expiration were to occur today the option would expire completely worthless. As you can see, the short spread leg has helped to smooth volatility while the market trends against the initial forecast.
At this point the spread could be closed by buying to close the short leg and selling to close the long leg. However, for the purposes of this series of articles I will leave the spread alone and see how prices look at March expiration. The third article in this series will examine what the possible actions are at expiration and how the trade might be managed for the next month.
Calendar spreads can be market neutral or slightly biased to the upside or downside. In the example we used in this series, the calendar spread was biased to the downside in at least two ways.
Each of these biases become more important as expiration nears or the market moves with more volatility than the original forecast. This trade was originally established with a moderate bearish bias, which seemed prudent to account for the downward momentum in the market. The maximum gain in a calendar spread on a monthly basis, occurs if the market price equals the strike prices used at expiration.
Therefore some downside movement would have put the market price closer to that maximum gain. The second bias can be seen by the use of puts in the calendar spread.
Because a calendar spread is fairly neutral, calls would offer a similar risk profile as a spread but at expiration the short position expires and a long call or put is left. A bearish trader could leave the long put position active to take advantage of further downside momentum.
At expiration there are three things that can be done to end, extend or modify the calendar strategy. Unwind the trade by selling the long put The market has rallied since this case study started at the beginning of March The move has been enough to create a loss in the trade, however, the losses have been reduced by the premium from the short put. In that way, one of the strategic objectives have been achieved. At this point, if you thought the market was likely to continue to rally, exiting the position may be the best alternative.
Sell another 65 strike short term put In the original trade setup the 65 put with a March expiration was sold against the long 65 strike put with a September expiration. The extra income helps to reduce the basis and maximum loss that this trade could still be exposed to in the long term. Leave the long put uncovered As an analyst you may decide that the market is at a potential resistance level and the long put could become profitable again as prices move back down.
Leaving the put uncovered provides for unlimited upside if the market falls significantly. This strategy would be superior to the second alternative of extending the spread if the market falls below the original strike price.
All three alternatives are acceptable depending on market volatility and your own personal tolerance for risk. The take-away from this segment of the series on calendar spreads is to understand that time spreads require some decision making after the short term expiration. This allows for some flexibility and may offer cost savings over shorter term vertical spreads as the long side of the spread does not always have to be reentered or adjusted.
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