Order Entry: Net Debit
Ideal Environment: Low IV
Profit Target: 25%
Definition: A calendar spread consists of selling an option (call or put) in the near-term expiration cycle, while simultaneously buying an option (call or put) in a longer-term expiration cycle. Both options have to be the same type and have the same strike price. The trade results in net debit and is an overall neutral position. Calendar spreads have defined risk, so the max loss is known during order entry. The strategy makes money in a low IV (Implied Volatility) underlying asset that has an IV expansion while staying near the strike price of the options.
Calendar Spread Setup
Sell 1 near-term Put/Call
Buy 1 longer-term Put/Call
(Keep in the short/long options have to be the same type and strike price)
The max profit for a calendar spread is not possible to calculate as it involves two options that expire during different expiration cycles. The profit of the trade is based off of IV expanding in the underlying asset. In order to determine max profit, we have to know what the IV is of the underlying asset would be as the near-term option expired. Since that cannot be predicted at order entry, it makes it difficult to know what our max profit would be for the trade.
Max Profit = ???
Similar to the explanation above about max profit, it is difficult to determine the breakeven points of the trade without knowing the IV when the near-term option expires.
Break-even Point(s) = ???
Calendar spreads lose money when IV in the underlying asset continues to contract or the stock price moves too far away from the strike price. The max loss can be calculated at order entry, which is the difference between the paid amount for the long option and the premium collected for the short option.
Max Loss = Premium Paid (long option) – Credit Received (short option)
Suppose stock ABC is trading at $100 in January and has low IV. An options trader is neutral on ABC decides to enter a calendar spread by selling an ATM $100 call for $200 in February and buying at ATM $100 call in April for $700. The options have different DTE. The trade results in a debit of $500.
In February, the price of ABC stock is trading at $99 but the IV has expanded. Both the short and long calls have increased in price. Due to longer term options having larger increases in price during IV expansion, the trade is currently in the profit. The short term option is worth $250, but the long term option is $850. If the spread is sold, the position would net $100 (current $600 debit – order entry $500 debit).
If the price settled at $101 in February but the IV continued to contract, the trade most likely ended in a loss. The ITM long call is worth $550 but the short call is worth $150. If the spread is sold, the trade would lose $100 (current $400 debit – order entry $500 debit).
If the stock had fallen to $80 in February, the trade would have resulted in a loss. The long call is has little value left as the $100 call is way OTM with two months until expiration. The short call is worthless. If the long call had a value of $200, the loss on the trade would be $300 (current $200 debit – order entry $500 debit).
When to use a calendar spread strategy?
At Tradezy, we recommend to use this strategy for stocks with a low implied volatility. The trader should have a short to intermediate neutral thesis. In term of strike selection we look to be close to the current trading price of the stock unless we want to add a slightly bearish/bullish skew to our strike selection. Since calendar spreads tend to get hurt when there are large swings in stock price, we look to manage winners at 25% profit of what we paid for the spread at order entry.