OAP 079: How To Trade Calendar Spreads – The Complete Guide

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Today's podcast is all about learning how to trade calendar spreads. And while newbie traders might find them a little difficult to understand conceptually at first, I think you'll find our talk today to be incredibly helpful as we break down these time spreads from start to finish. During the show, I'll walk through setting up and building calendar spreads, the impact of implied volatility and time decay, how to adjust and exit as well as the best market setups for these low IV option strategies.

Key Points from Today's Show:

  • A calendar spread takes advantage of the pricing differential that may start to develop between a front month option and a back month option.
  • Most calendar spreads are set up to have a one-month differential.

Setting Up a Calendar Spread

  • To set up, first sell the front month option and then buy the same strike price and contract back month option for the next month. For example, you might sell the 50 strike puts in January, and then buy the 50 strike puts in February or March.
  • This takes advantage only in the difference in time between the two monthly contracts.
  • The key is to use the exact same strike price and the exact same type of option.
  • When scanning for great calendar spread trades, look for low IV rank like we found using our Watch List Software.

Price of a Calendar Spread

  • The price that you pay for a calendar spread is the difference between selling the front month and buying the back month contract.
  • This debit that you pay becomes your max loss at the first expiration date.

Example:

The USO ETF trades at $11.72. Looking at the January-February call calendar in USO, the January strike calls are trading for $16-$17. The exact same 12 strike calls in February are trading for $34-$36. To create a new call calendar spread for USO, sell January's calls, collect a premium of $16-$17 and then buy the back-month calls -- February calls. The next debit will be ~$20. This is your max loss for the January expiration date.

Once you get to the January expiration, those February options may still have value that could be lost if you go past the January expiration. Therefore most calendars are managed in the front month expiration.

Calendar Spread

Calendar Spread Potential Profit

  • Potential profit is hard to peg on calendars because it depends on the difference between the strike prices as you get towards expiration.
  • Calendars are only concerned with extrinsic value in the different contract months -- time value and volatility value.
  • Intrinsic value is always the same and directly offset from one contract to another because you are trading the exact same strike in opposite directions.
  • Maximum potential profit will be achieved if the stock lands at your strike price, at front month expiration.
  • The payoff diagram can expand or contract with volatility as you get closer to expiration. Example of simulated higher implied volatility is below.

Calendar Spread Option Strategy

When Are Calendars Best Used?

  • Calendar spreads can be used in any direction — bullish, bearish, or neutral around the stock.
  • Backtesting shows the best success comes when you are either slightly bullish or slightly bearish on the stock.
  • To balance your portfolio, can use a calendar spread to trade in the direction of where you need your portfolio to move.
  • Calendar spreads are best suited during periods of low to high volatility.
  • During periods of high volatility, option prices are going to expand and time decay will be less on the back month contracts that you are long.

Adjusting Calendar Spreads

  • Calendar spreads are usually very cheap positions that do not need as much adjustment.
  • If a trade is going in the opposite direction of where you think it is going to go, roll your short strike as the market is moving.
  • With a put calendar spread, if the stock price increases, roll up your puts to move in the direction of the market.
  • Another adjustment strategy is to add another position, creating a double calendar spread — not a preferred strategy.

Example:

For the 12 strike call calendar spread for USO stock, if USO price falls, roll down the short 12 calls for a credit which helps reduce the cost of the calendar spread and transfers some of the risk, shifting your payoff diagram lower.

Exiting and Closing Out Calendar Spreads

  • Sell the back month option, buy back your front month option, and close the position for a higher price.
  • If you reach expiration and the stock has not moved as well as expected and your options are both out of the money, can let your front month option expire and keep the back month option as a lottery ticket for the next 30 days.

Example:

Assumed USO would move up to 12 strikes for call calendar, but USO stayed lower all the way through the expiration cycle. Will still get some benefit from the January decay in the options, but when you reach January expiration, could choose to leave the 12 calls long for February. These act as lottery tickets for February, hoping that USO price moves higher.

*Remember to check the value at January expiration.

Example:

If the USO 12 call for February is still worth $35, if you leave it on you could still lose an additional $35 because that is now a new value that could be lost after the January front month expiration. The best time to leave these on as lottery tickets is if they are worth a really small amount.

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Free Options Trading Courses:

  • Options Basics [20 Videos]: Whether you're a completely new trader or an experienced trader, you'll still need to master the basics. The goal of this section is to help lay the groundwork for your education with some simple, yet important lessons surrounding options.
  • Finding & Placing Trades [26 Videos]: Successful options trading is 100% dependent on your ability to find and enter trades that give you an "edge" in the market. This module helps teach you how to scan properly for and select the best strategies to execute smarter option trades each day.
  • Pricing & Volatility [12 Videos]: This module includes lessons on mastering implied volatility and premium pricing for specific strategies. We'll also look at IV relativeness and percentiles which help you determine the best strategy to use for each and every possible market setup.
  • Neutral Options Strategies [7 Videos]: The beauty of options is that you can trade the market within a neutral range either up or down. You'll learn to love sideways and range bound markets because of the opportunity to build non-directional strategies that profit if the stock goes up, down or nowhere at all.
  • Bullish Options Strategies [12 Videos]: Naturally everyone wants to make money when the market is heading higher. In this module, we'll show you how to create specific strategies that profit from up trending markets including low IV strategies like calendars, diagonals, covered calls and direction debit spreads.
  • Options Expiration & Assignment [11 Videos]: Our goal is to make sure you understand the logistics of how each process works and the parties involved. If you don’t feel confident in the expiration processes or have questions that you just can't seem to get answered, then this section will help you.
  • Portfolio Management [16 Videos]: When I say "portfolio management" some people automatically assume you need a Masters from MIT to understand the concept and strategies - that is NOT the case. And in this module, you'll see why managing your risk trading options is actually quite simple.
  • Trade Adjustments/Hedges [15 Videos]: In this popular module, we'll give you concrete examples of how you can hedge different options strategies to both reduce potential losses and give yourself an opportunity to profit if things turn around. Plus, we'll help you create an alert system to save time and make it more automatic.
  • Professional Trading [14 Videos]: Honestly, this module isn't just for professional traders; it's for anyone who wants to have eventually options replace some (or all) of their monthly income. Because the reality is that mindset is everything if you truly want to earn a living trading options.

Option Trader Q&A w/ George

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. This week's question comes from George who asks:

How do you set up the conditional orders to close trades of a certain stock if the market hits a certain situation. For example, if the S&P drops 100-300 points and you want it to trigger to close all trades if that situation were to happen, how do you do that?

Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.

PDF Guides & Checklists:

  • The Ultimate Options Strategy Guide [90 Pages]: Our most popular PDF workbook with detailed options strategy pages categorized by market direction. Read the whole guide in less than 15 mins and have it forever to reference.
  • Earnings Trading Guide [33 Pages]: The ultimate guide to earnings trades including the top things to look for when playing these one-day volatility events, expected move calculations, best strategies to use, adjustments, etc.
  • Implied Volatility (IV) Percentile Rank [3 Pages]: A cool, simple visual tool to help you understand how we should be trading based on the current IV rank of any particular stock and the best strategies for each blocked section of IV.
  • Guide to Trade Size & Allocation [8 Pages]: Helping you figure out exactly how to calculate new position size as well as how much you should be allocating to your each position based on your overall portfolio balance.
  • When to Exit/Manage Trades [7 Pages]: Broken down by option strategy we'll give you concrete guidelines on the best exit points and prices for each trade type to maximize your win rate and profits long-term.
  • 7-Step Trade Entry Checklist [10 Pages]: Our top 7 things you should be double-checking before you enter your next trading. This quick checklist will help keep you out of harms way by making sure you make smarter entries.

Real-Money, LIVE Trading:

  • EWZ Iron Butterfly (Closing Trade): After nearly pinning the stock at our short strikes, and thanks to the volatility drop, we netted a $600 profit on this iron butterfly trade.
  • VXX Short Call (Closing Trade): One of the most consistent and profitable options trades we can make is shorting pure volatility with VXX and today we closed this naked short call in VXX after a couple days for a $420 profit.
  • DIA Iron Condor (Adjusting Trade): This neutral iron condor in DIA is need of a quick adjustment early this week as the market continues to rally. In this video, we'll discuss why I'm adding an additional put credit spread while also choosing NOT to close out of our current put credit spread due to pricing reasons.
  • COP Short Put (Closing Trade): These single short puts in COP acted as a great hedge for our other bearish bets in oil this month and helped smooth out our returns after we closed them for a nice big profit.
  • TSLA Put Debit Spread (Closing Trade): Although many people thought we were crazy for getting bearish in TSLA this pre-earnings put debit spread trade made us $200 today. After the huge run up from $140 to $260 and getting some technical sell signals, we were pretty sure this stock would pull back.
  • MON Iron Condor (Closing Trade): Following a huge drop in implied volatility we worked hard to close this MON iron condor trade adjusting the order multiple times to fill before the end of the day.
  • IBB Call Debit Spread (Opening Trade): We'll show you how I started searching for a new bullish trade and eventually found a low volatility trade in IBB looking for a move higher to hedge our portfolio.
  • TLT Iron Butterfly (Closing Trade): Following the Brexit vote TLT and bonds traded in a nearly $8 range really quickly - even still the drop in implied volatility helped generate a $330 profit for us.
  • XBI Call Debit Spread (Closing Trade): Got lucky picking the exact bottom for our entry in this call debit spread for the XBI biotech ETF which ultimately was closed for a profit of $165 today on the rally higher.
  • COH Iron Butterfly (Earnings Trade): Shortly after the market open we close out of our COH earnings trade for about a $160 profit, leaving just 1 leg on to expire worthless.
  • EWW Debit Spread (Closing Trade): Using some of the technical analysis signals we discovered in our backtesting research, we were able to make a quick $130 profit on this bearish EWW debit spread trade.
  • IBM Iron Condor (Earnings Trade): Shortly after the market opened you'll follow along with me as we watch volatility drop and liquidity come into the market before closing out the position for $250 profit.
  • SLV Short Straddle (Opening Trade): Using our watch list software we decided to continue to add to our existing SLV short straddle position with a new set of strike prices reflective of the move lower in the ETF recently.

Thank You for Listening!

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About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. In 2018, Option Alpha hit the Inc. 500 list at #215 as one of the fastest growing private companies in the US. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and three children.